Suppose the rate of return on a 10-year T-bond is currently 5.00% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.10%. Suppose further that the maturity risk premium on a 10-year T-bond is 1.0%, that no maturity risk premium is required on TIPS, and that no liquidity premiums are required on any T-bonds. Given this data, what is the expected rate of inflation over the next 10 years

1.90%

Explanation:

For TIPS provide rate of real rate,

Inflation rate=return on T bond-return on TIPS-maturity risk premium and it is equal to

= 5%-2.10%-1%=1.90%.

Therefore the expected rate of inflation over the next 10 years is 1.90%

The inflation rate over the next 10 years = 1.90%.

Explanation:

Nominal interest rate = real risk-free rate + inflation premium + default risk premium + liquidity premium +maturity risk premium.

Making Inflation premium the subject of the formula, we have:

Inflation premium = Nominal interest rate - real risk-free rate -inflation premium -  default risk premium - liquidity premium - maturity risk premium.

Inflation premium = 5% - 2.10% - 0 -0 -1.0% = 1.90%.

Therefore, the inflation rate over the next 10 years = 1.90%.

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