Treasury securities that mature in 6 years currently have an interest rate of 8.5%.Inflation is expected to be 5% each of the next three years and 6% each year after the third year.The maturity risk premium is estimated to be 0.1%(t - 1), where it is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero).The real risk-free rate is assumed to be constant over time.What is the real risk-free rate of interest?

Question

Quizplus · Accepted Answer

The nominal interest rate is the sum of the real risk-free rate, expected inflation, and the maturity risk premium. Given the nominal rate is 8.5%, expected inflation is 5% for the first three years and 6% for the next three years, and the maturity risk premium is 0.5% (0.1% * (6 - 1)), the real risk-free rate can be calculated as 8.5% - (average inflation rate over 6 years) - 0.5%. The average inflation rate is (5%*3 + 6%*3)/6 = 5.5%. Therefore, the real risk-free rate is 8.5% - 5.5% - 0.5% = 2.5%.

Treasury Securities That Mature in 6 Years Currently Have an Interest