Question

The real risk-free rate is 1.15% and inflation is expected to be 1.75% next year and 2.25% the following year. A 2-year Treasury security yields 4.15%. What is the maturity risk premium for a 2-year security?

Answer 1

The maturity risk premium for a 2-year Treasury security is calculated by subtracting the sum of the real risk-free rate and average expected inflation from the security's yield, which results in a 1% premium.

Step-by-step explanation:

To calculate the maturity risk premium for a 2-year Treasury security, we need to compare the nominal yield with the sum of the real risk-free rate and expected inflation. Given that the real risk-free rate is 1.15% and the expected inflation is 1.75% for the first year and 2.25% for the second year, we first find the average expected inflation rate over the two years. The average inflation is (1.75% + 2.25%) / 2 = 2%. We then add this to the real risk-free rate to get the nominal risk-free rate, which is 1.15% + 2% = 3.15%.

Now, we can compute the maturity risk premium by subtracting the nominal risk-free rate from the yield of the Treasury security. The 2-year Treasury security yields 4.15%, so the maturity risk premium is 4.15% - 3.15% = 1%. Therefore, the maturity risk premium for the 2-year security is 1%.