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?
if you invest twice as much in a term deposit that pays 3% annuual interest than you do in a money market that pays 2% annual interest, how much do you have in each account in order to earn $20 of interest in one year?
To calculate the maturity risk premium on the two-year Treasury security, we first need to understand the components that make up the interest rate on this security:
1. Real interest rate: This is the rate of return on an investment after adjusting for inflation. In this case, the real interest rate is expected to be 3.00 percent per year.
2. Inflation premium: This is the compensation an investor receives for expected inflation over the investment period. In this case, the inflation premium is expected to be 2.00 percent per year.
3. Maturity risk premium: This is the additional compensation that investors require for holding a longer-term security as there is more uncertainty associated with longer maturities.
To calculate the maturity risk premium, we need to subtract the real interest rate and the inflation premium from the total interest rate.
Given that the two-year Treasury security currently earns 5.25 percent, we can calculate the maturity risk premium as follows:
Total interest rate = Real interest rate + Inflation premium
Total interest rate = 3.00% + 2.00% = 5.00%
Maturity risk premium = Total interest rate - Real interest rate - Inflation premium
Maturity risk premium = 5.25% - 3.00% - 2.00% = 0.25%
Therefore, the maturity risk premium on the two-year Treasury security is 0.25 percent.