Suppose the real risk-free rate of interest is r*=5%
 and it is expected to remain constant over time. Inflation is expected to be 1.40% per year for the next two years and 3.50% per year for the next three years. The maturity risk premium is 0.1×(t−1)%
, where t
 is number of years to maturity, a liquidity premium is 0.55%, and the default risk premium for a corporate bond is 1.30%.
The average inflation during the first 3 years is    .

The average inflation rate during the first 3 years can be found by taking the arithmetic mean of the given inflation rates over this period. Since we know the expected inflation rates for the next two years and the third year is also specified separately, we can set it up as follows:

- Inflation for the first 2 years: \( 1.40\% \) each year.
- Inflation for the third year: \( 3.50\% \).

The average inflation rate during the first 3 years is calculated as:

\[
\text{Average Inflation} = \frac{\text{Inflation in Year 1} + \text{Inflation in Year 2} + \text{Inflation in Year 3}}{3}
\]

Substituting the values:

\[
\text{Average Inflation} = \frac{1.40\% + 1.40\% + 3.50\%}{3}
\]

Calculating this:

\[
\text{Average Inflation} = \frac{6.30\%}{3} = 2.10\%
\]

So, the average inflation during the first 3 years is **2.10%**.

Would you like a detailed breakdown of the calculations or have any other questions related to this topic? 

Here are some follow-up questions:
1. How does the maturity risk premium change with different years to maturity?
2. What is the formula for calculating the total interest rate considering all risk premiums?
3. How do liquidity premiums affect bond prices?
4. What is the impact of inflation on the real rate of return?
5. How would the default risk premium vary for a bond with a different credit rating?

**Tip**: When calculating average rates over multiple periods, ensure you take the arithmetic mean unless the problem specifies a different method, like geometric mean.

Suppose the real risk-free rate of interest is r*=5% and it is expected to remain constant over time. Inflation is expected to be 1.40% per year for the next two years and 3.50% per year for the next three years. The maturity risk premium is 0.1×(t−1)%, where t is number of years to maturity, a liquidity premium is 0.55%, and the default risk premium for a corporate bond is 1.30%. The average inflation during the first 3 years is    .

Learn how to calculate the average inflation over three years with inflation rates of 1.40% for two years and 3.50% for the third year. This problem also explores bond risk premiums such as maturity risk, liquidity premium, and default risk premium. Suitable for high school and college students studying economics or finance.

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