suppose the real risk - free is 3.50% and the future rate of inflation is expected to be constant at 6.80% . What rateof return would you expect on a 1 yr Treasury security , assuming the pure expectations theory is valid? Disregard cross- product terms, i.e., if averaging is required use the arithmetic average.
6.8% + 3.5% = 10.3%
To calculate the expected rate of return on a 1-year Treasury security using the pure expectations theory, you need to consider the real risk-free rate and the expected rate of inflation.
Step 1: Calculate the expected nominal risk-free rate.
First, add the real risk-free rate to the expected rate of inflation to obtain the nominal risk-free rate. In this case:
Nominal Risk-Free Rate = Real Risk-Free Rate + Expected Rate of Inflation
= 3.50% + 6.80%
= 10.30%
Step 2: Calculate the expected rate of return.
The expected rate of return is equal to the nominal risk-free rate:
Expected Rate of Return = Nominal Risk-Free Rate
= 10.30%
Therefore, the expected rate of return on a 1-year Treasury security, assuming the pure expectations theory is valid, is 10.30%.