Question

An investor in Treasury securities expects inflation to be 1.8% in Year 1, 2.2% in Year 2, and 3.15% each year thereafter. Assume that the real risk-free rate is 1.75% and that this rate will remain constant. Three-year Treasury securities yield 5.20%, while 5-year Treasury securities yield 6.00%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 - MRP3? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

The difference is computed as shown below:

Inflation Premium 3 is computed as follows:

= (1.8% + 2.2% + 3.15%) / 3

= 2.3833333%

Inflation Premium 5 is computed as follows:

= (1.8% + 2.2% + 3.15% + 3.15% + 3.15%) / 5

= 2.69%

MRP3 is computed as follows:

Yield on 3 year treasury securities = real risk free rate + Inflation Premium 3 + MRP3

5.20% = 1.75% + 2.38333333% + MRP3

MRP3 = 1.06666667%

MRP5 is computed as follows:

Yield on 5 year treasury securities = real risk free rate + Inflation Premium 5 + MRP5

6% = 1.75% + 2.69% + MRP5

MRP5 = 1.56%

So, the difference is computed as follows:

= 1.56% - 1.06666667%

= 0.49%