Problem 6-12. Maturity risk premium An investor in Treasury securities expects i
ID: 2672383 • Letter: P
Question
Problem 6-12. Maturity risk premiumAn investor in Treasury securities expects inflation to be 1.75% in Year 1, 3.4% in Year 2, and 3.6% each year thereafter. Assume that the real risk-free rate is 2.3%, and that this rate will remain constant. Three-year Treasury securities yield 6.55%, while 5-year Treasury securities yield 7.50%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 - MRP3? Round your answer to two decimal places.
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Problem 6-10. Inflation
Due to a recession, expected inflation this year is only 2%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 2%. Assume that expectations theory holds and the real risk-free rate is r* = 3.25%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 2.25%, what inflation rate is expected after Year 1? Round your answer to two decimal places.
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Explanation / Answer
Problem 6-12: First, calculate the inflation premiums for the next three and five years, respectively. They are: IP3 = (1.75% + 3.4% + 3.6%)/3 = 2.91% IP5 = (1.75% + 3.4% + 3.6% + 3.6% + 3.6%)/5 = 3.19%. The real risk-free rate (r*) is given as 2.3%. Since the default and liquidity premiums are zero on Treasury bonds, we can now solve for the maturity risk premium. 6.55% = 2.3% + 2.91% + MRP3 MRP3 = 1.34%. 7.5% = 2.3% + 3.19% + MRP5, MRP5 = 2.01%. Thus, MRP5 – MRP3 = 2.01% – 1.34% = 0.67%.