Chapter 6, Problem 3P

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# EXPECTED INTEREST RATE The real risk-free rate is 2.25%. Inflation is expected to be 2.5% this year and 4.25% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?

Summary Introduction

To identify: The yield on 2 year and 3 year treasury securities

Introduction:

Yield:

The percentage of securities at which the company provides the return to its investors is a yield. Yield can be there in the form of dividend and interest.

Explanation

In order to calculate the yield on 2 year and 3 year securities, the inflation rate for the 2 year and 3 year need to be calculated.

Inflation rate:

2 Year

Given,

Inflation rate for the first year is 2.5%.

Inflation during next 2 years is 4.25%.

Formula to calculate the inflation rate,

Expectedāinflationārate=Inflationāatāfirstāyear+Inflationāatātheāsecondāyear2

Substitute 2.5% for inflation at first year and 4.25% for inflation at second year.

Expectedāinflationārate=2.5%+4.25%2=6.75%2=3.375%

The expected inflation rate for 2 year bond is 3.375%.

3 year

Given,

Inflation rate for the first year is 2.5%.

Inflation during next 2 years is 4.25%.

Formula to calculate the inflation rate,

Expectedāinflationārate=(Inflationāatāfirstāyear+Inflationāatātheāsecondāyear+Inflationāatātheāthirdāyear)3

Substitute 2

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