( Real interest rates: approximation method ) The CFO of your firm has asked you

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 5.17 percent, the 30-year Treasury bond rate is7.58 percent, and the inflation rate is 2.92 percent. Also, the chief financial officer wants a short explanation should the 3-month real rate turn out to be less than the30-year real rate.

Explanation / Answer

Maturity risk premium of the investments with long-term duration is always higher than the maturity risk premium of the same kind of lower duration investment. The difference between the rate of returns of the same class of investments can be called as maturity risk premium.

Hence,

Maturity risk premium is 2.41% (7.58%-5.17%)

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