Question

Suppose the rate of return on a 10-year T-bond is 6.90%, the expected average rate of inflation over the next 10 years is 2.0%, the MRP on a 10-year T-bond is 0.9%, no MRP is required on a TIPS, and no liquidity premium is required on any Treasury security. Given this information, what should the yield be on a 10-year TIPS? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Answer 1

4%

Step-by-step explanation:

We start with the nominal rate of return and then we adjust it to inflation.

real rate of return = nominal rate of return - inflation rate = 6.9% - 2% = 4.9%

finally we must subtract the maturity risk premium (MRP) of the bonds:

bond yield = real rate of return - MRP = 4.9% - 0.9% = 4%