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MATURITY RISK PREMIUM An investor in Treasury securities expects inflation to be 2.5% in Year 1, 3.2% in Year 2, and 3.6% each year thereafter. Assume that the real risk-free rate is 2.75% and that this rate will remain constant. Three-year Treasury securities yield 6.25%, while 5-year Treasury securities yield 6.80%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 MRP3?
Answer : First, calculate the inflation premiums for the next three and five years, respectively. IP3 = (2.5% + 3.2% + 3.6%)/3 = 3.1% IP5 = (2.5% + 3.2% + 3.6% + 3.6% + 3.6%)/5 = 3.3%. The real risk-free rate is given as 2.75%. Since the default and liquidity premiums are zero on Treasury bonds, we can…

solve for the maturity risk premium. We have, 6.25% = 2.75% + 3.1% + MRP3; We get ,MRP3 = 0.4%. Also, 6.8% = 2.75% + 3.3% + MRP5; We get ,MRP5 = 0.75%. So, MRP5 MRP3 = 0.75% 0.40% = 0.35%.



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