If the pure expectations theory is correct, what does the market believe that year securities will be yielding 4 years from now? EXPECTED INTEREST RATE The real risk-free rate is 3%

Finance Dec 03, 2020

If the pure expectations theory is correct, what does the market believe that year securities will be yielding 4 years from now? EXPECTED INTEREST RATE The real risk-free rate is 3%. Inflation is expected to be this year, 45 next year, and 39%, thereafter. The maturity risk premium is estimated to be 0.05 (t-1% where t = number of years to maturity. What is the yield on a 7-year Treasury note?

Expert Solution

Real Risk free rate = 3%

Inflation Premium = Average of Inflation over 7 years

Inflation Premium = (3% + 4% + 5 * 3.5%) / 7

Inflation Premium = 3.5%

Maturity Risk Premium = 0.05 * (t - 1)%,

Maturity Risk Premium = 0.05 * (7 - 1)%

Maturity Risk Premium = 0.30%

Yield on 7-year Treasury Note = Real Risk-free Rate + Inflation Premium + Maturity Risk Premium

Yield on 7-year Treasury Note = 3% + 3.5% + 0.30%

Yield on 7-year Treasury Note = 6.8%

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