Treasury securities that mature in 6 years currently have an interest rate of 8.5%.Inflation is expected to be 5% each of the next three years and 6% each year after the third year.The maturity risk premium is estimated to be 0.1%(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 8.5%, expected inflation averages 5.5% over 6 years, and the maturity risk premium is 0.5%, the real risk-free rate is 2.5%.

Treasury Securities That Mature in 6 Years Currently Have an Interest