Question

An investor in Treasury securities expects inflation to be 1.55% in Year 1, 2.85% in Year 2, and 4.3% each year thereafter. Assume that the real risk-free rate is 2.45% and that this rate will remain constant. Three-year Treasury securities yield 6.50%, while 5-year Treasury securities yield 7.90%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 - MRP3? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

The difference is computed as shown below:

Inflation Premium 3 is computed as follows:

= (1.55% + 2.85% + 4.3%) / 3

= 2.9%

Inflation Premium 5 is computed as follows:

= (1.55% + 2.85% + 4.3% + 4.3% + 4.3%) / 5

= 3.46%

MRP3 is computed as follows:

Yield on 3 year treasury securities = real risk free rate + Inflation Premium 3 + MRP3

6.50% = 2.45% + 2.9% + MRP3

MRP3 = 1.15%

MRP5 is computed as follows:

Yield on 5 year treasury securities = real risk free rate + Inflation Premium 3 + MRP5

7.90% = 2.45% + 3.46% + MRP5

MRP5 = 1.99%

So, the difference is computed as follows:

= 1.99% - 1.15%

= 0.84%

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