Question

The real risk-free rate is 2.55%, inflation is expected to be

5.70% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, i.e., if averaging is required, use the arithmetic average, what is the equilibrium rate of return on a 1-year treasury bond?
a. 6.98%
b. 4.13%
c. 2.55%
d. 8.25%
e. 2.70%

Answer 1

The equilibrium rate of return on a 1-year Treasury bond is the sum of the real risk-free rate (2.55%) and expected inflation (5.70%), which equals 8.25% (d).

Step-by-step explanation:

The equilibrium rate of return on a 1-year Treasury bond can be determined by adding the real risk-free rate of interest to the expected rate of inflation, given that the maturity risk premium is zero and cross-product terms are ignored. This is consistent with the Fisher Effect, which states that the nominal interest rate is equal to the sum of the real risk-free rate and the expected inflation rate.

Therefore, the equilibrium rate of return on the bond would be the sum of the real risk-free rate of 2.55% and the expected inflation rate of 5.70%. Performing this addition:

2.55% (Real risk-free rate) + 5.70% (Inflation) = 8.25%

The correct answer is d. 8.25%.