Can anyone give some color around why the 1-yr treas note uses the long term inflation rate in the risk premium approach instead of the current inflation rate?
Even the text states that the inflation premium should reflect the average inflation expected over the maturity of the debt.
I’m not sure why were using a long term rate for 1 yr debt.
current inflation rate does not reflect expectations for the future.
Sure, But I would think current Inflation would more accurately represent next year’s expectations than a long term inflation rate. Am I thinking about this incorrectly, is the inflation from one period to the next completely uncorrelated?
From a Capital markets expectation perspective - a longer term - (I believe they use 12-15 years) is more reasonable… So the long term rate should be used.
Investor is evaluation three secs…1 yr note, 10 yr corporate bond (callable) & 10 yr MBS
for 1 yr note return should be real risk free int. + current inflation rate
Current/short term int rate are less than 1 year inflation rate, this should be used instead of long term inflation expectation. Is in it?
Not per the answer, it uses the long term inflation rate for all three.
Follow up question: any thoughts as to why the 10 year MBS doesn’t include the 1% premium for spread of 10 year over 1 year treasury note? The only premium shown is the 10 year MBS prepayment risk spread, but that’s over 10 year treasuries.
For the MBS, there is a subnote that says it’s a govn’t backed MBS (think GNMA) so there is no spread over the 10yr Treas. Which leaves, Rf, inflation and prepayment spreads.
I get why there isn’t a spread over the 10 year treasury, but shouldn’t they include the spread for the 10 year treasury over the 1 year treasury? Otherwise you’re not being compensated for the extended holding period.
10-year MBS prepayment risk spread (over 10-year Treasuries)a 95 bps
fine print - fine note a
aThis spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk.
Fine print / footnotes are as important !
bond yield plus risk premium use 10 year bonds ( long term ) not 1 year notes… read the text. Page 41 ok Bk 3