Inflation affects purchasing power of money and therefore has a major effect on interest rates. Therefore if inflation rate is expected to be 1% during the next year this is added to the risk free interest rate (say 3.5%) and so the Treasury bill rate will be: rT-bill = rRF = r* + IP = 3.5% + 1% = 4.5% The inflation rate is the main factor which determines the shape of the treasury yield curve. If the inflation rate is expected to increase, then the treasury yield curve will slope upwards; which is normal. On the other hand, if the inflation rate is expected to decrease, then this will cause the treasury yield curve to slope downwards. Another factor affecting the Treasury bill rate is interest rate risk. When interest rates rises the prices of treasury bonds decline sharply and since this is a regular occurrence all long term bonds including treasury bonds have an element of interest rate risk. A maturity risk premium (say 2.5%) is therefore added to the risk free rate resulting in the following formula for calculating the Treasury bill rate. rT-bill = rRF = r* + IP + MRP. = 3.5% + 1% + 2.5 = 7% This premium increases with the time to maturity. Therefore, the longer the period the higher maturity risk premium. ...

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