You are considering an investment in a U.S.Treasury bond but you are not sure what rate of interest it should pay.Assume that the real risk-free rate of interest is 1.0%; inflation is expected to be 1.5%; the maturity risk premium is 2.5%; and,the default risk premium for AAA rated corporate bonds is 3.5%.What rate of interest should the U.S.Treasury bond pay?

Question

Quizplus · Accepted Answer

The interest rate on a U.S. Treasury bond can be calculated by adding the real risk-free rate of interest (1.0%) to the expected inflation (1.5%), since U.S. Treasury bonds are considered free of default risk and the maturity risk premium applies to them. Therefore, the rate of interest should be 1.0% + 1.5% = 2.5%. However, the inclusion of the maturity risk premium (2.5%) should also be considered for longer-term bonds, making the correct calculation 1.0% + 1.5% + 2.5% = 5.0%. The default risk premium for AAA rated corporate bonds is not relevant for U.S. Treasury bonds.

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