Question

An investor in Treasury securities expects inflation to be 2% in Year 1, 3.2% in Year 2, and 4.4% each year thereafter. Assume that the real risk-free rate is 2.35% and that this rate will remain constant. Three-year Treasury securities yield 6.90%, while 5-year Treasury securities yield 8.05%. 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% + 3.2% + 4.4%) / 3

**= 3.2%**

**Inflation Premium 5 is computed as follows:**

= (2% + 3.2% + 4.4% + 4.4% + 4.4%) / 5

**= 3.68%**

**MRP3 is computed as follows:**

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

6.90% = 2.35% + 3.2% + MRP3

**MRP3 = 1.35%**

**MRP5 is computed as follows:**

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

8.05% = 2.35% + 3.68% + MRP5

**MRP5 = 2.02%**

**So, the difference is computed as follows:**

= 2.02% - 1.35%

**= 0.67%**

**Feel free to ask in case of any query relating to this
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