5-year Treasury bonds yield 4.4%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*?

A. 2.10%
B. 2.39%
C. 2.21%
D. 2.58%
E. 1.91%

A. 2.10%

Explanation:

Treasury nods yield includes the real risk free rate, Inflation premium and maturity risk premium as well.

Treasury Bonds Yield = Real Risk free rate + Inflation premium + Maturity risk premium

4.4% = Real Risk free rate + 1.9% + 0.4%

4.4% = Real Risk free rate + 2.3%

Real Risk free rate = 4.4% - 2.3%

Real Risk free rate = 2.1%

A. 2.10%

Explanation:

The risk-free rate can simply be described as the interest or rate of return that is expected by be paid on an absolutely risk-free investment to an investor over a given time period.

The real risk-free rate (r*) is estimated by deducting the summation of the inflation premium (IP) and the maturity risk premium (MRP) from the yield to maturity (YTM). That is,

r* = YTM – (IP + MRP) …………………………………….. (1)

Substituting for the respective values in the question into equation (1), we have:

r* = 4.4% – (1.9% + 0.4%) = 4.4% – 2.3% = 2.1%

Therefore, the real risk-free rate, r*, is 2.1%.

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