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A 6-year Treasury bond has an interest rate of 8.5 percent. Inflation is expected to be...

A 6-year Treasury bond has an interest rate of 8.5 percent. Inflation is expected to be 5 percent each of the next three years and 6 percent each year after the third year. The maturity risk premium is estimated to be 0.1%(t-1), where t is equal to the maturity of the bond. The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest?

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Answer #1

Inflation rate for each of next 3 years is 5% and for each of next 3 years is 6%

Inflation Premium = [3 * 5% + 3 * 6%] / 6
Inflation Premium = 33% / 6
Inflation Premium = 5.50%

Maturity Risk Premium = 0.10% * (t - 1), where t is equal to the maturity of the bond
Maturity Risk Premium = 0.10% * (6 - 1)
Maturity Risk Premium = 0.50%

6-year Treasury Bond Yield = Real Risk-free Rate + Inflation Premium + Maturity Risk Premium
8.50% = Real Risk-free Rate + 5.50% + 0.50%
8.50% = Real Risk-free Rate + 6.00%
Real Risk-free Rate = 2.50%

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