Question

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 2.50%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Answer 1

The rate of return that you would expect on a 4-year Treasury security is 7.10%

Rate on return = real rate + inflation rate + per yr. maturity risk premium * T yrs. of maturity

Explanation:

The Formula for the

Rate on return = Real rate + inflation rate + per yr. maturity risk premium * T yrs. of maturity

Given ,that

Real risk free rate =4.20%

Inflation Rate=2.50%,

Maturity Risk premium=0.10%

Putting all the values in the above equation

Rate of return = 4.20% + 2.50% + (0.10%*4)

Rate of return=6.80%*4

Rate of return= 7.10%

The maturity risk premium is

= 0.10% × 4

= 0.40%

In the above solution  we have added the real rate, inflation rate and the maturity risk premium ,so that we can arrive on the value of the  rate on return of a treasury security .