Question

The real risk-free rate is 2.55%, inflation is expected to be 2.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond? What would it be if the approximation method is used? Show work and 4 decimals.

Answer 1

T-bond yield = [(1 + Real Risk-free Rate) * (1 + Inflation Rate)] - 1

= [(1 + 0.0255) * (1 + 0.0215)] - 1

= 1.047548 - 1

= 0.047548 or 4.7548%

Rate of return on a 1-year Treasury bond = 4.7548%