Question

# An investor in Treasury securities expects inflation to be 2% in Year 1, 3.2% in Year...

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.

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%

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