( Real interest rates: approximation method ) The CFO of your firm has asked you
ID: 2815226 • Letter: #
Question
(Real interest rates: approximation method) The CFO of your firm has asked you for an approximate answer to this question: What was the increase in real purchasing power associated with both 3-month Treasury bills and 30-year Treasury bonds? Assume that the current 3-month Treasury bill rate is 5.02 percent, the 30-year Treasury bond rate is 8.25 percent, and the inflation rate is 2.26 percent. Also, the chief financial officer wants a short explanation should the 3-month real rate turn out to be less than the 30-year real rate.
The inferred real interest rate of Treasury bills is ____%. (Round to two decimal places.)
The inferred real interest rate of Treasury bonds is ____%.c(Round to two decimal places.)
Should the 3-month real interest rate turn out to be less than the 30-year real interest rate?(Select the best choice below.)
A. Yes, the 30-year real interest rate should exceed the 3-month real interest rate because the two securities are sold in different markets.
B. Yes, the 30-year real interest rate should exceed the 3-month real interest rate because inflation only affects the long-term security.
C. Yes, the 30-year real interest rate should exceed the 3-month real interest rate because the goverment demands lower rates for lending short term.
D. Yes, the 30-year real interest rate should exceed the 3-month real interest rate because of the maturity premium demanded by investors.
Explanation / Answer
The inferred real interest rate for 3-month Treasury bill =
ANS : 3-month Treasury bill – Inflation rate = 5.02% - 2.26%=2.76%
The inferred real interest rate for 30-year Treasury bond =
ANS : 30-year Treasury bond – Inflation rate = 8.25% - 2.26%=5.99%
Should the 3-month real interest rate turn out to be less than the 30-year real interest rate?
ANS :D. Yes, the 30-year real interest rate should exceed the 3-month real interest rate because of the maturity premium demanded by investors.
EXPLANATION : The real interest rate for 3-month Treasury bond is less than the 30 year Treasury bill because the length of time of the investment is high in case of 30 years in comparison to 3 month & so as high risk is taken, the real rate has to be higher for 30 year treasury bond & lower for 3 month treasury bond
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