

The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year Treasury security yields 7.0%. What is the maturity risk premium for the 2-year security? Round your answer to one decimal place.

To find the maturity risk premium (MRP) for the 2-year Treasury security, we use the formula:

\[
\text{Nominal Rate} = (1 + \text{Real Risk-Free Rate})(1 + \text{Inflation Rate}) + \text{MRP}
\]

Alternatively, we can approximate it as:

\[
\text{Nominal Rate} \approx \text{Real Risk-Free Rate} + \text{Inflation Rate} + \text{MRP}
\]

We know the following values:
- Real Risk-Free Rate (\(r^*\)) = 3% or 0.03
- Expected Inflation Rate (\( \text{inflation} \)) = 3% or 0.03
- Treasury Security Yield (\(\text{Nominal Rate}\)) = 7% or 0.07

Now, solving for the maturity risk premium (MRP):

\[
\text{MRP} = \text{Nominal Rate} - (\text{Real Risk-Free Rate} + \text{Inflation Rate})
\]

Substitute the known values:

\[
\text{MRP} = 7\% - (3\% + 3\%)
\]
\[
\text{MRP} = 7\% - 6\% = 1\%
\]

Thus, the maturity risk premium for the 2-year security is **1.0%**.

Would you like more details or have any questions?

Here are 5 related questions for further exploration:
1. How does the maturity risk premium change for longer-term securities?
2. What factors influence the real risk-free rate over time?
3. How would an unexpected change in inflation expectations affect Treasury yields?
4. Why is the maturity risk premium often higher for longer-term securities?
5. How does the liquidity premium differ from the maturity risk premium?

**Tip**: When estimating interest rates, always consider the effect of inflation, as it can significantly impact real returns over time.

The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year Treasury security yields 7.0%. What is the maturity risk premium for the 2-year security? Round your answer to one decimal place.

Find the maturity risk premium for a 2-year Treasury security given a 3% real risk-free rate, 3% inflation rate, and a 7% nominal yield. This step-by-step solution is suitable for high school students in Grades 11-12 and covers key financial concepts like nominal rates, inflation, and risk premiums.

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