If you expect the inflation premium to be 2%, the default risk premium to be 1%, and the real interest rate to be 4%, then what interest rate would you expect to observe in the marketplace on short-Term Treasury Securities?
To calculate the expected interest rate on short-term Treasury securities, we need to consider the components that make up the total interest rate: the real interest rate, inflation premium, and default risk premium.
The real interest rate is the base rate at which lenders are willing to loan money, adjusted for inflation. In this case, the given real interest rate is 4%.
The inflation premium accounts for the expected rate of inflation. It represents the additional return lenders demand to compensate for the erosion of purchasing power due to inflation. Here, the inflation premium is 2%.
Finally, the default risk premium reflects the additional return lenders require to compensate for the risk of default on the loan. In this scenario, the default risk premium is 1%.
To calculate the expected interest rate on short-term Treasury securities, we sum up these three components:
Expected Interest Rate = Real Interest Rate + Inflation Premium + Default Risk Premium
= 4% + 2% + 1%
= 7%
Therefore, based on the given expectations for the inflation premium, default risk premium, and real interest rate, one would expect to observe an interest rate of 7% in the marketplace on short-term Treasury securities.