Suppose 1-year Treasury bills currently yield 7.00% and the future inflation rate is expected to...

Question:

Suppose 1-year Treasury bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year.

What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

a. 3.80%

b. 3.99%

c. 4.19%

d. 4.40%

e. 4.62%

Risk-free Rate

In Finance, treasury bills are often considered as risk-free because it is assumed that governments will not default on its promises. This riskless security has a rate of return composed of the real risk-free rate and expected inflation premium.

Answer and Explanation:

Given the following information,

{eq}Treasury = 0.07 {/eq}

{eq}Inflation = 0.0320 {/eq}

{eq}Risk-free_{rate} = real_{rate} + inflation {/eq}

The one-year treasury bill rate of 7% already includes the inflation rate of 3.20% and therefore, in order to find the real risk-free rate we need to subtract the inflation from the treasury rate.

{eq}Real_{rate} = 0.07 - 0.0320 {/eq}

{eq}Real_{rate} = 0.0380 {/eq}

The real risk-free rate of return is 3.80% (a).


Learn more about this topic:

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How to Calculate Risk Premium: Definition & Formula

from Financial Accounting: Help and Review

Chapter 5 / Lesson 26
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