) Suppose 1-year T-bills currently yield 5.00% and the future inflation rate is
ID: 2366657 • Letter: #
Question
) Suppose 1-year T-bills currently yield 5.00% and the future inflation rate is expected to be constant at 3.10% per year. What is the real risk-free rate of return, r*? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. (10p) a. 1.90% b. 2.00% c. 2.10% 24) Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%, and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. (10p) a. 6.05% b. 6.15% c. 6.25%Explanation / Answer
Yield on T- bills K = Risk free rate + Inflation rate
5.00% = Risk free rate + 3.10%
Risk free rate = 5.00% - 3.10%
= 1.90%
Risk free rate = 3.50%
Inflation rate = 2.25%
return on treasury security = 3.50% + 2.25%
= 5.75%
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