2. Interest rates A two-year Treasury security currently earns 5.25 percent. Over the next two years, the real interest rate is expected to be 3.00 percent per year and the inflation premium is expected to be 2.00 percent per year. What is the maturity risk premium on the two-year Treasury security?
1.40
To calculate the maturity risk premium on a two-year Treasury security, you need to understand the components that contribute to the interest rate. In this case, we have the real interest rate and the inflation premium. The real interest rate represents the adjusted interest rate after considering inflation, while the inflation premium reflects the expected increase in prices over time.
Here's how you can calculate the maturity risk premium:
Step 1: Start with the given information:
Real interest rate = 3.00%
Inflation premium = 2.00%
Two-year Treasury security rate = 5.25%
Step 2: Calculate the expected nominal interest rate over the two-year period.
Nominal interest rate = Real interest rate + Inflation premium
Nominal interest rate = 3.00% + 2.00%
Nominal interest rate = 5.00%
Step 3: Calculate the difference between the expected nominal interest rate and the actual rate on the two-year Treasury security.
Maturity risk premium = Nominal interest rate - Two-year Treasury security rate
Maturity risk premium = 5.00% - 5.25%
Maturity risk premium = -0.25%
The maturity risk premium on the two-year Treasury security is -0.25%. This negative value indicates that the expected nominal interest rate is lower than the actual rate, meaning the market is demanding a higher return for holding this security due to perceived higher risk associated with its maturity.