Suppose the real risk-free rate is 3.00%,the average expected future inflation rate is 2.25%,and a maturity risk premium of 0.10% per year to maturity applies,i.e.,MRP = 0.10%(t),where t is the years to maturity.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is NOT valid? Include the cross-product term,i.e.,if averaging is required,use the geometric average.
A)5.15%
B)5.42%
C)5.69%
D)5.97%
E)6.27%

Question

Quizplus · Accepted Answer

According to the Fisher effect, the nominal rate is equal to the real rate plus the expected inflation rate. Using this formula, the expected 1-year nominal rate would be:
Nominal rate = Real rate + Expected inflation rate + MRP
Nominal rate = 3.00% + 2.25% + 0.10%(1)
Nominal rate = 5.35%
However, the pure expectations theory assumes that investors expect the same rate of return on all maturities, and therefore the MRP would be 0. To include the MRP, we need to use the expectations theory with a term premium. The formula is:
Nominal rate = Real rate + Expected inflation rate + Term premium
The term premium for a 1-year Treasury security is assumed to be equal to the MRP for that maturity, so the term premium in this case is 0.10%. Therefore, the expected 1-year nominal rate with MRP is:
Nominal rate = 3.00% + 2.25% + 0.10%
Nominal rate = 5.35%
So, we can see that the answer choices are close to this rate but only answer choice B is within a reasonable range of error, it's the best choice.

Suppose the Real Risk-Free Rate Is 3