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The real risk-free rate is 2%, and inflation is expected to be 3% this year, 4%...

The real risk-free rate is 2%, and inflation is expected to be 3% this year, 4% in year 2, 5% in year 3 and then 3.5% thereafter. The maturity risk premium is estimated to be 0.50x(t-1), where t=number of years to maturity. What is the nominal interest rate on a 15-year Treasury security?

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Answer #1

Nominal Yield on Treasury Security = Real risk free rate + Inflation premium + Maturity risk premium

Inflation premium is average of inflation over life of bond.

So for 15 year bond, inflation premium = [3% + 4% + 5% + (3.5% * 12)]/15 = 3.60%

Maturity risk premium = 0.5*(15-1)% = 7%

Nominal yield = 2% + 3.60% + 7% = 12.60%

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