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Understanding TIPS


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How can I calculated the inflation assumptions built into TIPS prices?


You need to look at individual bonds as inflation expectations are priced at different rates across the term structure. For example as of this moment we have (from http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/ )


10-Year Treasury has a yield of 2.22%

10-Year TIPS has a real yield of 0.01%


So the inflation expectation is 2.22 - 0.01 = 2.21%. Since TIPS do not theoretically have inflation risk, there is a certain amount of inflation risk premium built into this 2.21%. If we assume the inflation risk premium to be say about 0.5% (just a guess), then the inflation expectation can be said to be 2.21 - 0.5 = 1.71%. Most people just assume inflation risk premium to be negligible and just use 2.21% as the inflation expectation.


You can do this across the different maturities to get the inflation expectation at that particular term.


Note: The nominal and inflation Treasuries used above have a slightly different maturity dates since they are not issued on the same date.




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