Assume that the real risk-free rate of return, r*, is 3 percent, and it will remain at that level far into the future.
Also assume that maturity risk premiums on Treasury bonds increase from zero for bonds that mature in one year or less to a maximum of 2 percent, and MRP increases by 0.2 percent for each year to maturity that is greater than one year—that is, MRP equal 0.2 percent for a two-year bond, 0.4 percent for a three-year bond, and so forth. Following are the expected inflation rates for the next five years:
YEAR INFLATION RATE
1 3.0%
2 5.0
3 4.0
4 8.0
5 3.0
a. What is the average expected inflation rate for a one-, two-, three-, four-, and five-year bond?
b. What should be the MRP for a one-, two-, three-, four-, and five-year bond?
c. Compute the interest rate for a one-, two-, three-, four-, and five-year bond.