Suppose the yield on a two-year Treasury bond is 5% and the yield on a one-year Treasury bond is...

Question:

Suppose the yield on a two-year Treasury bond is 5% and the yield on a one-year Treasury bond is 4%.

f the maturity risk premium (MRP) on these bonds is zero (0), what is the expected one-year interest rate during the second year (Year 2)?

Maturity Risk Premium:

The maturity risk premium is the additional return on bonds with a longer term to maturity. This premium is usually positive, implying that bonds with longer term to maturity is considered riskier by investors.

Answer and Explanation:

We can use the following formula to compute the forward interest rate:

  • {eq}(1 + \text{2-year bond yield})^2 = (1 + \text{1-year bond yield}) *(1 + \text{expected one-year rate in year 2}) + \text{maturity risk premium} {/eq}
  • {eq}(1 + 5\%)^2 = (1 + 4\%) *(1 + \text{expected one-year rate in year 2}) + 0\% {/eq}
  • {eq}\text{expected one-year rate in year 2}) = 6\% {/eq}

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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