Question

5 year treasury bonds yield 6.4%. The inflation premium (IP) is 1.9%, and the maturity risk (MRP) on 5 year bonds is 0.4%. What is the real risk free rate, r*?

Answer 1

Solution:

The Formula for calculating the Yield on Treasury Bonds is

Yield on Treasury Bond = Real Risk free rate + Inflation premium + Default risk premium + Market Risk premium + Liquidity premium

Y = r* + IP + DRP +MRP + LP

As per the information given in the question we have

Yield on Treasury Bond = 6.4 % ; Inflation premium = 1.9 %   ; Default risk premium = Nil ;

Market Risk premium = 0.4 %   ; Liquidity premium = Nil

Real Risk free rate = To find

Applying the available information in the formula we have

6.4 % = Real Risk free rate + 1.9 % + Nil + 0.4 % + Nil

6.4 % = Real Risk free rate + 1.9 % + 0.4 %

6.4 % - 1.9 % - 0.4 % = Real Risk free rate

Real Risk free rate = 6.4 % - 1.9 % - 0.4 %

Real Risk free rate = 4.1 %

Thus the Real Risk free rate ( r* ) = 4.1 %