Question

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 4.20%, 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. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms.

	a.	8.54%
	b.	8.80%
	c.	8.01%
	d.	7.92%
	e.	7.22%

Answer 1

Answer is 8.80%

Real Risk-free Rate = 4.20%
Inflation Premium = 4.20%

Maturity Risk Premium = 0.10% * t, where t is number of years
Maturity Risk Premium = 0.10% * 4
Maturity Risk Premium = 0.40%

Return on 4-year Treasury Security = Real Risk-free Rate + Inflation Premium + Maturity Risk Premium
Return on 4-year Treasury Security = 4.20% + 4.20% + 0.40%
Return on 4-year Treasury Security = 8.80%