Problem:
A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year Treasury bond has an interest rate of 2.5 percent. A maturity risk premium is estimated to be 0.2 percentage points for the longer maturity bond. Investors expect inflation to average 1.5 percentage points over the next ten years.
Required:
Question 1: Estimate the expected real rate of return on the ten-year U.S. Treasury bond.
Question 2: If the real rate of return is expected to be the same for the thirty-year bond as for the ten-year bond, estimate the average annual inflation rate expected by investors over the life of the thirty-year bond.
Note: Show supporting computations in good form.