Suppose the real risk-free rate is 4.20%,the average expected future inflation rate is 4.20%,and a maturity risk premium of 0.10% per year to maturity applies,i.e. ,MRP = 0.10%(t),where t is the number of years to maturity,hence the pure expectations theory is NOT valid.What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

Question

Quizplus · Accepted Answer

According to the pure expectations theory, the expected return on a Treasury security is equal to the average of expected future short-term interest rates. However, in this question, we are told that the pure expectations theory is not valid because of the presence of a maturity risk premium.

To calculate the required rate of return, we need to add the various components:

Expected inflation = 4.20%
Real risk-free rate = 4.20%
Maturity risk premium = 0.10%(4) = 0.40%

Total required rate of return = 4.20% + 4.20% + 0.40% = 8.80%

Therefore, the correct answer is B, 8.80%.

Suppose the Real Risk-Free Rate Is 4