Question

1. An investor in Treasury securities expects inflation to be 1.8% in Year 1, 3.3% in Year 2, and 3.65% each year thereafter. Assume that the real risk-free rate is 1.7% and that this rate will remain constant. Three-year Treasury securities yield 6.25%, 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.

%

2. The real risk-free rate is 2.00%, and inflation is expected to be 2.00% for the next 2 years. A 2-year Treasury security yields 9.00%. What is the maturity risk premium for the 2-year security? Round your answer to two decimal places.

%

Answer 1

1. Re = Rf + inflation risk premium + maturity risk premium

Inflation risk premium for year 3 = 1.8 + 3.3 + 3.65/ 3

= 2.916

The yield on the 3 year treasury security = 6.25%

6.25 = 1.7 + 2.916 + MRP3

Or, MRP = 1.634%

MRP3 = 1.634

The MRF5 will be :

The yield on the 5 year treasury security is 7.2%,

inflation risk premium =( 1.8 + 3.3 + 3.65 + 3.65 + 3.65)/5

=3.21

So, the MRP will be:

7.2 = 1.7 + 3.21 + MRP

or, 2.29 = MRP5

So, MRP5 - MRP3

= 2.29 - 1.634

=0.656

=0.66 (rounded off to two decimal places)

2. The MRP for the 2 year security is :

yield on the 2 year security is = 9%

inflation risk premium = (2 + 2)/2

= 2%

Yield on security = risk free rate + inflation premium + maturity risk premium

9% = 2% + 2 % + MRP

MRP2 = 5%