Question

Determinants of Interest Rates The real risk-free rate is 4%. Inflation is expected to be 4% this year, 5% next year, and then 4.5% thereafter. The maturity risk premium is estimated to be 0.0006 × (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.

Answer 1

Answer:

Determinants of Interest Rates The real risk-free rate is 4%. Inflation is expected to be 4% this year, 5% next year, and then 4.5% thereafter. The maturity risk premium is estimated to be 0.0006 × (t - 1), where t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury security?

The nominal interest rate = 8.86%.

Explanation:

Average inflation premium = (4%+5%+4.5%+4.5%+4.5%+4.5%+4.5%)/7 = 31.5%/7 = 4.50%

Maturity risk premium for 7 year bond = 0.0006 * (7-1) = 0.36%

Nominal interest rate = real risk free rate + inflation premium + maturity risk premium = 4% + 4.50% + 0.36% = 8.86%.

Therefore, the nominal interest rate for the question given = 8.86%.