Solved Question: Projections for inflation for the next few years are as follows

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Question:

Projections for inflation for the next few years are as follows:

year 1       2%

year 2       3%

year 3       5%

a) Calculate (and show your work) the inflation premium for a 2-year bond — in other words, what is the average annual inflation over this bond’s life?

b) Calculate (and show your work) the inflation premium for a bond maturing in 3 years — in other words, what is the average annual inflation over the life of this bond?

Answer:

a. Inflation for the bond = 1.02 * 1.03 =1.0506
Annualized premium = √1.0506= 0.0249 or 2.4988%

b. Total inflation for a 3 year bond = 1.02 *1.03 * 1.05 = 1.1031
Annualized premium = (1.1031) ^1/3 = 3.3258%

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