Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% 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?
A)2.1%
B)1.8%
C)5.0%
D)3.0%
E)2.5%

Question

Quizplus · Accepted Answer

The yield on a bond is the sum of the real risk-free rate, expected inflation, and the maturity risk premium. For both bonds, the yield is 12%. The average expected inflation over 2 years is (9% + 6%)/2 = 7.5%, and over 5 years is (9% + 6% + 4% + 4% + 4%)/5 = 5.4%. The maturity risk premium difference is calculated as (12% - 4% - 5.4%) - (12% - 4% - 7.5%) = 2.1%.

Assume That the Real Risk-Free Rate, R*, Is 4 Percent