Question

Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 4.10%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Answer 1

Answer: 6.6%

Explanation:

The Pure Expectations Theory believes that the future long term rate is a reflection of future short term rates.

In terms of a 5 Treasury Security then, the rate of return to be expected is the risk free rate adjusted for inflation.

The Treasury Security has no risk but for inflation risk hence this is all that should be catered for.

Rate of Return on 5 year Treasury Security = Real Risk Free Rate + Inflation Rate

= 2.5% + 4.1%

= 6.6%