Problem:
Suppose the annual yield (r) on a 2-year (2011-2012) Treasury bond is 7.5%, while that on a 1-year bond (2011) is 5%. r* is 2% and the risk premium is zero.
Requirement:
Question 1: Forecast the interest rate (r) on a 1-year bond during the second year (2012)
Question 2: What is the expected inflation premium (IP) in Year 2011 and Year 2012? Given: r=r* + IP. Explain in detail and also provide step by step solution.