The real risk free rate is 5%. Inflation is expected to be 3% this year, 3.5% next year, and 4% thereafter. The maturity risk premium is estimated to be 0.1*(t-1)%, where t= number of years to maturity. What is yield on a 3 year treasury note?

8.7%

Explanation:

Given that,

Real risk free rate = 5%

Expected inflation:

This year = 3%

Next year = 3.5% and thereafter = 4%

Estimated maturity risk premium = 0.1 × (t - 1)%

t = number of years to maturity

Average inflation rate:

= (3% + 3.5% + 4%) ÷ 3

= 3.5%

Estimated maturity risk premium:

= 0.1 × (t - 1)%

= 0.1 × (3 - 1)%

= 0.2%

Therefore,

Yield on a 3 year treasury note:

= Real risk free rate + Average inflation rate + Estimated maturity risk premium

= 5% + 3.5% + 0.2%

= 8.7%

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