Question

suppose the rate of return on a 10-year t-bond is 7.45%, the expected average rate of inflation over the next 10 years is 1.60%, the mrp on a 10-year t-bond is 0.90%, 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

To determine the yield on a 10-year Treasury Inflation-Protected Security (TIPS), we need to consider the various components: the real risk-free rate, expected inflation, and the maturity risk premium (MRP).

The formula to calculate the yield on a TIPS is as follows:

Yield on TIPS = Real Risk-Free Rate + Expected Inflation + MRP for TIPS

Given the information provided:

Rate of return on a 10-year T-bond = 7.45%

Expected average rate of inflation over the next 10 years = 1.60%

MRP on a 10-year T-bond = 0.90% (as mentioned)

No MRP is required on TIPS

No liquidity premium is required on any Treasury security

Now, let's calculate the yield on a 10-year TIPS:

Yield on TIPS = Rate of return on a 10-year T-bond - Expected Inflation + MRP for TIPS

= 7.45% - 1.60% + 0.00%

= 5.85%

Therefore, the yield on a 10-year TIPS, without considering cross-product terms, is 5.85%.

Please note that this calculation assumes the absence of cross-product terms and liquidity premium, and the numbers used are for illustrative purposes and may not reflect the current market conditions.