Fundamentals of Financial Manageme...
Solutions
Fundamentals of Financial Manageme...
MATURITY RISK PREMIUM An investor in Treasury securities expects inflation to be 2.1% in Year 1, 2.7% in Year 2, and 3.65% each year thereafter. Assume that the real risk-free rate is 1.95% and that this rate will remain constant. Three-year Treasury securities yield 5.20%, while 5-year Treasury securities yield 6.00%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 − MRP3?
To identify: The maturity risk premium.
Introduction:
Maturity Risk Premium:
A premium, which is paid by the borrower to its lender in the form of compensation of the interest rate uncertainty in regards of the maturity risk, is known as the maturity risk premium.
The items required for the calculation of the maturity risk are risk free rate, Treasury bill yield and inflation premium.
Year 3
The yield is 5.20%. (Given)
The risk free rate is 1.95%. (Given)
The inflation premium on 3 year treasury security is 2.82%. (Working note)
Formula to calculate the maturity risk premium derives from the formula of corporate bond yield,
Where,
- MRP is the maturity risk premium.
- r is the corporate bond yield.
- r* is the risk free rate.
- IP is the inflation premium.
Substitute 5.20% for r, 1.95% for r* and 2.82% for IP.
The maturity risk premium on year 3 treasury security is 0.43%.
Year 5
The yield is 6%. (Given)
The risk free rate is 1.95%. (Given)
The inflation premium on 5 year treasury security is 3.15%. (Working note)
Substitute 6.8% for r, 2.75% for r* and 2.82% for IP.
The maturity risk premium on year 5 treasury security is 0.9%.
Compute the difference between two maturity risks
Calculated,
Formula to calculate the difference between two maturity risks,
Substitute, 0.43% for
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