Assume that the real risk-free rate is 4 percent, and that inflation is expected to be 9 percent in Year 1, 6 percent in Year 2, and 4 percent 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 percent, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP2? (Round answer to one decimal place.)
A)2.1%
B)1.8%
C)0.5%
D)3.1%
E)2.6%

Question

Quizplus · Accepted Answer

The MRP on a bond is the difference between the bond's yield and the expected inflation rate over the life of the bond. For the 2-year bond, the MRP is 12% - (4% + 6%)/2 = 2.1%. For the 5-year bond, the MRP is 12% - (4% + 6% + 4%)/3 = 1.8%. Therefore, the difference in the MRPs is 2.1% - 1.8% = 0.3%.

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