Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
A) 5.08%
B) 5.35%
C) 5.62%
D) 5.90%
E) 6.19%

Question

Quizplus · Accepted Answer

Using the formula for the Fisher effect, we have: 
Nominal rate = Real rate + Expected inflation rate + MRP 
Nominal rate = 3.00% + 2.25% + 0.10%(1) 
Nominal rate = 5.35% 
Therefore, we would expect a rate of return of 5.35% on a 1-year Treasury security, assuming the pure expectations theory is NOT valid.

Suppose the Real Risk-Free Rate Is 3