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30 July, 05:16

12. 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 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?

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  1. 30 July, 07:30
    0
    6.8%

    Explanation:

    Formula: r = r * + IP + MRP + DRP + LP.

    Therefore:

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

    r * = 0.03

    IP = 0.03+0.04=0.07

    0.07+5*0.035=0.245

    0.245/7=0.035

    The maturity risk premium was provided in the problem as:

    0.05 x (t - 1) %

    MRP = 0.05 (7-1) %

    = 0.05 (6%) = 0.0030

    DRP = 0

    LP = 0

    Addition of all will be:

    rt7 = 0.03 + 0.035 + 0.0030 = 0.068 = 6.8%

    The yield on a 7-year Treasury note is 6.8%
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