Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5% in 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 t 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. For a 6-year bond, the maturity risk premium is 0.1% × (6 - 1) = 0.5%. The average expected inflation over 6 years 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