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.
A.  Estimate
the expected real rate of return on the ten-year U.S. Treasury bond.
B.  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.

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