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. Also, assume 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?

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Quizplus · Accepted Answer

The expected inflation rate over 2 years is the average of 9% and 6%, which is 7.5%. For 5 years, it's the average of 9%, 6%, and three years of 4%, which is 5.4%. Using the formula for yield: Yield = r* + Inflation + MRP, we find MRP2 = 0.5% and MRP5 = 2.6%. Thus, MRP5 - MRP2 = 2.1%.

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