Question

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 6.60%
b. 7.70%c. 8.80%d. 9.90%

Answer 1

Answer:

b. 7.70%

Explanation:

The computation of the rate of return is shown below:

= Real risk free rate + inflation rate + maturity risk premium

= 4.20% + 3.10% + 0.40%

= 7.70%

The maturity risk premium is

= 0.10% × 4

= 0.40%

Basically we added the risk free rate, inflation rate and the maturity risk premium so that the rate on return on a treasury security could come