A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year Treasury bond has an interest rate of 3.7 percent. If inflation is expected to average 1.5 percentage points over both the next ten years and thirty years, determine the maturity risk premium for the thirty-year bond over the ten-year bond.
To determine the maturity risk premium for the thirty-year bond over the ten-year bond, we need to consider the difference in interest rates and the expected inflation rates for both bonds.
The interest rate for the thirty-year bond is 4.0 percent, while the interest rate for the ten-year bond is 3.7 percent. The difference in interest rates is 4.0% - 3.7% = 0.3%.
Inflation is expected to average 1.5 percentage points over both the next ten years and thirty years. So, the expected inflation rate for both bonds is 1.5%.
To calculate the maturity risk premium, we need to subtract the expected inflation rate from the difference in interest rates.
Maturity Risk Premium = Difference in Interest Rates - Expected Inflation Rate
Maturity Risk Premium = 0.3% - 1.5% = -1.2%
The negative maturity risk premium indicates that the ten-year bond has a lower interest rate compared to the thirty-year bond, even after accounting for expected inflation.