Problema Solution
the real risk free rate of interest is 3%. inflation is expected to be 4% next year, 5% the following year and 6% year after. what should the ROR be for a 3 year risk free security?
Answer provided by our tutors
K = requiredreturn (or) yield on debt security
K* = realrisk-free rate of interest
IP = Inflationpremium
DRP = defaultrisk premium
LP = liquiditypremium
MRP = maturityrisk premium
Formula: K =K*+IP+DRP+LP+MRP
Inflation is expected to be 2% in the first year i.e.(IP1) = 2%
And 4% expected to be during the next 2 years i.e.(IP2) = 4% & (IP3) = 4%
K* = 3%
(IP1) = 2%
(IP2) = 4%
(IP3) = 4%
MRP = 0
Calculating Yield on 2-years Treasury Security(KT-2):
K = K* + IP2
Average Inflation for 2 years (IP2) = [(2%+4%) /2]
IP2 = 3%
Yield on 2-years Treasury Security (KT-2) = 3% +3%
= 6%
KT-2 = 6%
Calculating Yield on 3-years Treasury Security(KT-3):
Average Inflation for 3 years (IP3) = [(2%+4%+4%) /3]
IP3 = 3.33%
Yield on 3-years Treasury Security (KT-3) = 3% +3.33%
= 6.33%
KT-3= 6.33%