Suppose the yield on a 10year Tbond is currently 505 and tha

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.10%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T?bond. Given this information, what is the expected rate of inflation over the next 10 years? (Show all your work)

Solution

Treasury Inflation-Protected Securities, or TIPS, are used as a hedge against inflation. The principal value of TIPS increases with inflation and decreases with deflation, as measured by the CPI.

10-year T-bond Yield = 5.05%

10-year TIPS Yield = 2.10%

Maturity Risk Premium (MRP) on T-Bond = 0.90%

Maturity Risk Premium on TIPS = 0%

Expected Inflation Rate = 10Yr Yield on T-Bond - 10Yr yield on TIPS - MPR on T-Bond - MPR on TIPS

Expected Inflation Rate = 5.05% - 2.10% - 0.90% - 0% = 2.05% --> Answer