Question

Problem 4-19
Maturity Risk Premiums

Assume that the real risk-free rate, r*, is 2% and that inflation is expected to be 7% in Year 1, 6% 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 MRP₅minus MRP₂? Round your answer to two decimal places.

%

Answer 1

r_t = 4 % + IP_t +MRP_t

IP_S = ( Each year inflation ) / Number of years

= (7% +6% +3%+3%+3%) / 5

      = 4.4%

IP₂ = (7% +6% ) / 2

      = 6.5 %

Substitute the equation ,

r₅ = 2 % +4.4 % +MRP = 10 %

r₂ = 2% +6.5 % +MRP = 10 %

Now let's Solve MRP₅ , then find the defference

MRP₅ =10 % - 6.4 % = 3.6 %

MRP₂ = 10% - 8.5% = 1.5 %

Defference = 3.6 % - 1.5 %

                 =2.1 %