Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%, and a maturity premium of 0.10% per year to maturity applies, i. e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i. e., if averaging is required, use the arithmetic average.

5.85%

Explanation:

Suppose the real risk-free rate is 3.50%,  the average future inflation rate is 2.25%, and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity.  What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid?   Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

a. 5.75%

B. 5.85%

c. 5.95%

d. 6.05%

e. 6.15%

r = r* + IP + DRP + LP + MRP

r = 3.50% + 2.25% + 0 + 0 + .10% = 5.85%

definitely a

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