Question

An investor in Treasury securities expects inflation to be 2.15% in Year 1, 3.45% in Year 2, and 3.95% each year thereafter. Assume that the real risk-free rate is 1.95% and that this rate will remain constant. Three-year Treasury securities yield 6.15%, while 5-year Treasury securities yield 7.20%. 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:

= (2.15% + 3.45% + 3.95%) / 3

= 3.183333333%

Inflation Premium 5 is computed as follows:

= (2.15% + 3.45% + 3.95% + 3.95% + 3.95%) / 5

= 3.49%

MRP3 is computed as follows:

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

6.15% = 1.95% + 3.183333333% + MRP3

MRP3 = 1.01666667%

MRP5 is computed as follows:

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

7.20% = 1.95% + 3.49% + MRP5

MRP5 = 1.76%

So, the difference is computed as follows:

= 1.76% - 1.01666667%

= 0.74%

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