The Wall Street Journal reports that the rate on 3-year Treasury securities is 7.10 percent, and the 6-year Treasury rate is 7.35 percent. From discussions with your broker, you have determined that expected inflation premium is 2.60 percent next year, 2.85 percent in Year 2, and 3.05 percent in Year 3 and beyond. Further, you expect that real interest rates will be 3.55 percent annually for the foreseeable future. What is the maturity risk premium on the 6-year Treasury security?
Maturity Risk Premium is the extra yield a bond investor expects as time to maturity is longer and therefore there is a higher chance of default.
To find the maturity risk premium we need to re-engineer the bond yield formula as below:
Yield = Real interest rate + expected inflation rate + maturity risk premium
From the above equation we can determine liquidity premium as
maturity risk premium = Yield - (Real interest rate + expected inflation rate)
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