Determinants of Interest Rate for Individual Securities The Wall Street Journal

Question

Determinants of Interest Rate for Individual Securities The Wall Street Journal reports that the rate on 3-year Treasury securities is 8.45 percent, and the 6-year Treasury rate is 8.55 percent. From discussions with your broker, you have determined that expected inflation premium is 3.80 percent next year, 4.05 percent in Year 2, and 4.25 percent in Year 3 and beyond. Further, you expect that real interest rates will be 4.15 percent annually for the foreseeable future. What is the maturity risk premium on the 6-year Treasury security? 05% .35% 60% 15%

Explanation / Answer

Treasury security rate is composed of real risk-free rate, inflation premium and maturity risk premium.

3-year Inflation premium = (3.80 + 4.05 + 4.25)/3 = 4.03%

3-year T-rate = 8.45 = 4.15 + 4.03 + MRP

6-year Inflation premium = (3.80 + 4.05 + 4.25*4)/6 = 4.14%

Give 6-year T-rate = 4.15 + 4.14 + MRP = 8.55

MRP = 8.55 - 8.29 = 0.26%

I guess there must be some issue with the problem itself.

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