11) Assume that the real risk-free rate, r*, is 2% and that inflation is expecte

Question

11) Assume that the real risk-free rate, r*, is 2% and that inflation is expected to be 7% in Year 1, 5% in Year 2, and 3% thereafter. Assume also that all Treasury securities are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10%, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5 minus MRP2? Round your answer to two decimal places.

12) Because of a recession, the inflation rate expected for the coming year is only 4%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 4%. Assume that the real risk-free rate is r* = 2% for all maturities and that there are no maturity premiums. If 3-year Treasury notes yield 2 percentage points more than 1-year notes, what inflation rate is expected after Year 1?

Explanation / Answer

r* = 2%
r2 = r5 = 10%
MRP5 – MRP2 = ?

year

Inflation rate

I year

7%

2 year

5%

3year

3%

4year

3%

5year

3%

general formula is r = r* + IP + MRP

MRP2

IP2 = (7+5) / 2 = 6 and now put it in the general formula

r 2= r* + IP2 + MRP2
10 = 2 + 6 + MRP2
MRP2 = 2

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MRP5

IP5 = (7+5+3+3+3)/5 = 4.8

r 5= r* + IP5 + MRP5

10 = 3 + 4.8 + MRP5
MRP5 = 2.2

So the MRP5 – MRP2 = 2.2 – 2 = 0.2%

year

Inflation rate

I year

7%

2 year

5%

3year

3%

4year

3%

5year

3%

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