Question

The real risk free rate is 3%, inflation is expected to be 2% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year t-bond?.

Answer 1

The equilibrium rate of return on a 1 year T-bond is 5%

Equilibrium rate

This is the interest rate at which the demand meet the supply at a particular point.

Equilibrium rate of return

This is the sum of dividend yield plus the rate of capital gains.

we can also say that the equilibrium rate for a 1 year T-bond in this case is the sum of the real risk free rate and the expected inflation.

Data

• Real risk free rate = 3%
• Expected inflation = 2%

Hence, the equilibrium rate of return will be 3% + 2% = 5%.

From the above, the equilibrium rate of return is 5%

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