Treasury securities that mature in 6 years currently have an interest rate of 8.50 percent. Inflation is expected to be 5 percent in each of the next three years and 6 percent each year thereafter. The maturity risk premium is estimated to be 0.10% × (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. Given the nominal rate is 8.50%, expected inflation is 5% for the first three years and 6% thereafter, and the maturity risk premium is 0.10% × (6 - 1) = 0.50%, the real risk-free rate can be calculated as 8.50% - average inflation rate - maturity risk premium = 2.50%.

Treasury Securities That Mature in 6 Years Currently Have an Interest