Question

The real risk-free rate is 1.45% and inflation is expected to be 1.80% next year and 2.00% the following year. A 2-year Treasury security yields 4.50%. What is the maturity risk premium for a 2-year security? a) 0.30%

b) 0.55%
c) 0.60%
d) 1.00%
e) 1.15%

Answer 1

The maturity risk premium for a 2-year Treasury security, given the real risk-free rate of 1.45% and the average expected inflation of 1.90%, is calculated to be 1.15%. This is obtained by subtracting the expected return of 3.35% from the actual yield of 4.50%.

Step-by-step explanation:

To calculate the maturity risk premium for a 2-year Treasury security, we need to use the given yield on the Treasury note, the real risk-free rate, and the expected inflation rates for the next two years. The yield on a Treasury security comprises the real risk-free rate, expected inflation, and the maturity risk premium. The real risk-free rate is given as 1.45%, and the expected inflation is 1.80% for the first year and 2.00% for the second year. The average expected inflation over the two years is (1.80% + 2.00%) / 2 = 1.90%. Adding the average inflation to the real risk-free rate gives us the expected return without the maturity risk premium, which is 1.45% + 1.90% = 3.35%.

The actual yield of the Treasury security is 4.50%. Therefore, to find the maturity risk premium, we subtract the expected return without the maturity risk premium from the actual yield: 4.50% - 3.35% = 1.15%. Hence, the maturity risk premium for a 2-year Treasury security is 1.15%, which corresponds to option (e).