Question

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 5.90%, 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. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Answer 1

YIELD ON 1 YEAR TREASURY SECURITY = r* +IP + MRP

r* =risk free rate = 3% IP = 5.9%, MRP = 0.10%(t) = 0.10%(1) = 0.10%

YIELD ON 1 YEAR TREASURY SECURITY = r* +IP + MRP = 3% +5.9% + 0.10% = 9.00%

Answer : 9.00%