Question

The real risk-free rate of interest is 3.8%. Inflation is expected to be 2.5% this year and 4.0% during the next 2 years. . Assume that the maturity risk premium is 0.5% for 2-year and 0.8% for 3-year period. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?

Answer 1

Risk free rate now = 3.8%

Risk free rate after 2 years =Risk free rate * (1 +inflation for year 1) * (1 +inflation for year 2) =3.8% *1.025*1.04=4.0508%

Risk free rate after 3 years =Risk free rate * (1 +inflation for year 1) * (1 +inflation for year 2)* (1 +inflation for year 3)

=3.8% *(1.025) *(1.04) *(1.04)=4.2128%

Yield on 2 year securities = Risk free rate after 2 years *(1+maturity premium)

=4.0508*(1+0.005)=4.0710%

Yield on 3 year securities = Risk free rate after 3 years *(1+maturity premium)

=4.2128*(1+0.008)=4.2465%