Question

The real risk-free rate is 3.55%, inflation is expected to be 6.50% this year, and the maturity risk premium is zero. taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year treasury bond?

A)10.898%
B)12.234%
C)12.851%
D) 10.281%
E)11.000%

Answer 1

The equilibrium rate of return on a 1-year Treasury bond, with a real risk-free rate of 3.55% and expected inflation of 6.50%, is calculated using the Fisher equation to be approximately 10.281%.

Step-by-step explanation:

The student asked what the equilibrium rate of return on a 1-year Treasury bond would be, considering a real risk-free rate of 3.55%, expected inflation of 6.50%, and a maturity risk premium of zero. To calculate this, the Fisher effect is used, which describes the relationship between real returns, nominal returns, and inflation. The Fisher equation states that the nominal interest rate is equal to the real risk-free rate plus expected inflation, plus the product of the real risk-free rate, and expected inflation.

Therefore, the equation to find the nominal interest rate (equilibrium rate) is (1 + real risk-free rate) x (1 + inflation rate) - 1. Plugging in the values provided: (1 + 0.0355) x (1 + 0.065) - 1 which equals approximately 0.10281 or 10.281%. Based on the options provided, the correct answer is D) 10.281%.