Question

# Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to...

Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 10% in Year 1, 6% in Year 2, and 4% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP2?

The inflation for 2 year note is computed as shown below:

= ( 10% + 6%) / 2

= 8%

The inflation for 5 year note is computed as shown below:

= (10% + 6% + 4% x 3) / 5

= 5.6%

The yield on 2 year note is computed as follows:

= 8% + real risk free rate of 4%

= 12%

The yield on 5 year note is computed as follows:

= 5.6% + real risk free rate of 4%

= 9.6%

So, the difference between the maturity risk premium will be as follows:

12% + MRP2 = 9.6% + MRP5

MRP5 - MRP2 = 12% - 9.6%

= 2.4%

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