Assume that the real risk-free rate is 3% and that inflation
is expected to be 8% on year 1,5% in year 2,and 4%
thereafter.Assume also that all Treasury bonds are highly
liquid and free of default risk.
If 2-year and 5-year Treasury bonds both yield 10%,calculate
the difference in the maturity risk premium on the two
bonds.
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Answer / Vidhu Sharma
The Maturity Risk Premium (MRP) is the additional yield that investors require to hold longer-term bonds instead of shorter-term bonds. In this case, let's denote MRP2 as the MRP for a 2-year bond and MRP5 as the MRP for a 5-year bond.nnFirst, calculate the expected return on the risk-free investment (r) for each year:nn- Year 1: r1 = 3% + 8% = 11%n- Year 2: r2 = 3% + 5% = 8%n- Years 3 to 5: r3, r4, r5 = 3% + 4% = 7%
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