The Wall Street Journal reports that the rate on three-year Treasury securities is 7.00 percent, and the six-year Treasury rate is 7.25 percent. From discussions with your broker, you have determined that expected inflation premium is 1.75 percent next year, 2.25 percent in Year 2, and 2.40 percent in Year 3 and beyond. Further, you expect that real interest rates will be 3.75 percent annually for the foreseeable future. What is the maturity risk premium on the six-year Treasury security?

Question

Quizplus · Accepted Answer

The equation for the nominal interest rate is:

Nominal Interest Rate = Real Interest Rate + Inflation Premium

To find the maturity risk premium on the six-year Treasury security, we need to first calculate the expected inflation rates for each of the six years:

Year 1: 1.75% 
Year 2: 2.25% 
Year 3: 2.40% 
Year 4: 2.40% 
Year 5: 2.40% 
Year 6: 2.40%

Next, we calculate the expected nominal interest rate for the six-year Treasury security:

Expected Nominal Interest Rate = Real Interest Rate + Inflation Premium 
= 3.75% + 2.25% 
= 6.00%

The actual interest rate on the six-year Treasury security is 7.25%, so the maturity risk premium must be:

Maturity Risk Premium = Actual Interest Rate - Expected Nominal Interest Rate 
= 7.25% - 6.00% 
= 1.25%

Therefore, the answer is C) 1.10 percent.

The Wall Street Journal Reports That the Rate on Three-Year