Problem:
Assume that the real risk-free rate, r*, is at 3% and that inflation is expected to be at 8% in Year 1, 5% in Year 2, and 4% thereafter. Assume also that all Treasury securities are highly liquid and free of default risk.
Required:
Question: If 2-year and 5-year Treasury notes both yield 10%, what is the difference in the maturity risk premiums (MRPs) on two notes; that us, what is MRP5 minus MRP2?
Note: Provide support for rationale.