In other words for us treasury securities the nominal

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Unformatted text preview: ” All Things Considered (NPR), November 6, 2001, downloaded from Electric Library, In other words, for U.S. Treasury securities the nominal, or risk-free, rate for a given maturity varies with the inflation expectation over the term of the security.5 EXAMPLE The nominal interest rate, RF, for four maturities of U.S. Treasury securities on March 15, 2002, is given in column 1 of the following table. Assuming that the real rate of interest is 1%, as noted in column 2, the inflation expectation for each maturity in column 3 is found by solving Equation 6.4 for IPt. Although a 0.81% rate of inflation was expected over the 3-month period beginning March 15, 2002, a 2.55% average rate of inflation was expected over the 2-year period, and so on. An analysis of the inflation expectations in column 3 for March 15, 2002, suggests that at that time a general expectation of increasing inflation existed. Simply stated, the March 15, 2002, yield curve for U.S. Treasury securities shown 5. Although U.S. Treasury securities have no risk of default or illiquidity, they do suffer from “maturity, or interest rate, risk”—the risk that interest rates will change in the future and thereby affect longer maturities more than shorter maturities. Therefore, the longer the maturity of a Treasury (or any other) security, the greater its interest rate risk. The impact of interest rate changes on bond values is discussed later in this chapter; here we ignore this effect. 270 PART 2 Important Financial Concepts in Figure 6.3 was upward-sloping as a result of the expectation that the rate of inflation would increase in the future.6 Maturity, t Nominal interest rate, RFt (1) Real interest rate, k* (2) Inflation expectation, IPt [(1) (2)] (3) 3 months 1.81% 1.00% 0.81% 2 years 3.55 1.00 2.55 5 years 4.74 1.00 3.74 30 years 5.90 1.00 4.90 Generally, under the expectations theory, an increasing inflation expectation results in an upward-sloping yield curve; a decreasing inflation expectation results in a downward-slo...
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