Determinants of Interest Rates
The real risk-free rate is 3%. Inflation is expected to be 2% this year, 4% next year, and then 4% thereafter. The maturity risk premium is estimated to be 0.0003 x (t - 1), where t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury security? Do not round intermediate calculations. Round your answer to two decimal places.
Real Risk-free Rate = 3.00%
Inflation Premium = [2.00% + 4.00% + 5 * 4.00%] / 7
Inflation Premium = 26.00% / 7
Inflation Premium = 3.71%
Maturity Risk Premium = 0.0003 * (t - 1)
Maturity Risk Premium = 0.0003 * (7 - 1)
Maturity Risk Premium = 0.0018 or 0.18%
Nominal Interest Rate = Real Risk-free Rate + Inflation Premium
+ Maturity Risk Premium
Nominal Interest Rate = 3.00% + 3.71% + 0.18%
Nominal Interest Rate = 6.35%
So, nominal interest rate on a 7-year Treasury Security is 6.35%
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