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

Question

The real risk-free rate is 3%, and inflation is expected to be 3% this year, 4% next year, and 3.5% thereafter. The maturity risk premiuem is estimated to be 0.05X(t-1)% where t=number of years to maturity. What is the yield on 7-year Treasury note?

6-9 The real risk-free rate is 3%. Inflation is expected to be 3% this EXPECTED INTEREST RATE year, 4% next year, and 3.5% thereafter. The maturity risk premium is estimated to be 0.05 x (t-1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note?

Explanation / Answer

r = Real risk-free rate + Inflation premium + Default risk premium + Liquidity premium

Inflation Premium = (0.03 + 0.04 +(5)(0.035))/ 7

Inflation PRemium = 0.035

MRP = 0.05 * (7-1)% = 0.05 * (6%) = 0.0030

DRP = 0

LP = 0

Yield on treasury note = 0.03 + 0.035 + 0.0030 = 0.068

Yield on Treasury Note = 6.8%

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