Suppose you want the financial markets best guess about the expected annual inflation rate in five...

 

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Suppose you want "the financial markets" best guess about the expected annual inflation rate in five years. First, you obtain the yields-to-maturity on TIPS (Treasury Inflation Protected Securities) of various maturities (one-year to five-year) and find that these (inflation-adjusted or real) rates are constant over time at 4.2-percent. Second, you obtain information on the yields-to- maturity for U.S. Treasury bonds with maturities of 1 to 5 years. How would you use this information to determine the market estimate for the expected annual inflation rate in five years? Does it matter whether you adopt the unbiased expectations theory or the liquidity premium theory of the term structure? Carefully explain. Suppose you want "the financial markets" best guess about the expected annual inflation rate in five years. First, you obtain the yields-to-maturity on TIPS (Treasury Inflation Protected Securities) of various maturities (one-year to five-year) and find that these (inflation-adjusted or real) rates are constant over time at 4.2-percent. Second, you obtain information on the yields-to- maturity for U.S. Treasury bonds with maturities of 1 to 5 years. How would you use this information to determine the market estimate for the expected annual inflation rate in five years? Does it matter whether you adopt the unbiased expectations theory or the liquidity premium theory of the term structure? Carefully explain.

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Unbiased expectation theory uses the long term investment rate to calcula... View the full answer