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1 November, 09:15

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i. e., MRP = 0.10% (t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i. e., if averaging is required, use the arithmetic average.

a. 6.60%

b. 7.70%c. 8.80%d. 9.90%

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  1. 1 November, 09:18
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    b. 7.70%

    Explanation:

    The computation of the rate of return is shown below:

    = Real risk free rate + inflation rate + maturity risk premium

    = 4.20% + 3.10% + 0.40%

    = 7.70%

    The maturity risk premium is

    = 0.10% * 4

    = 0.40%

    Basically we added the risk free rate, inflation rate and the maturity risk premium so that the rate on return on a treasury security could come
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