Question

The real risk-free rate is 3.55%, inflation is expected to be 2.55% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond? what it does mean (Taking account of the cross-product term )??

Answer 1

Nominal Rate can be determined from the Real Rate and Inflation Rate using two separate methods. The first is an approximate method and the second is the accurate method.

Approximate Method: Nominal Rate = Real Rate + Inflation

Accurate Method: (1+Nominal Rate) = (1+Real Rate) x (1+Inflation) where the product of the real rates and inflation is the cross product term. As the question specifically mentions not to ignore the cross product term, one has tp use the accurate method for calculating the nominal rate.

Real Risk-Free Rate = RRFR = 3.55 % and Inflation Rate = I = 2.55 %

Therefore, Nominal Risk-Free Rate = NRFR = [(1+RRFR) x (1+I)] - 1 = [(1.0355) x (1.0255)] -1 = 0.06191 or 6.191 %

Maturity Risk Premium = 0 %

Therefore, Equilibrium Rate on One-Year Treasury Bond = NRFR + Maturity Premium = 6.191 + 0 = 6.191 %