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    Real Risk Free Rate of Interest

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    Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5% each of the next three years and 6% each year after the third year. The maturity risk premium is estimated to be 0.1% (t-1), where t is equal to the maturity of the bond (i.e. the maturity risk premium of a one year bond if zero). The real risk free rate is assumed to be constant over time. What is the real risk free rate of interest?

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    Solution Preview

    First, use the following formula to get the inflation rate over the next 6 years:
    (1+ inflation)^6 = ...

    Solution Summary

    The solution explains the concepts very well, and determines the real risk free rate of interest. All the steps are clearly explained and outlined. The answer is very easy to understand and can be followed along with anyone who has a basic understanding of the subject. Overall, an excellent response to the question.