Question

The following table shows $1,000 face value Treasury bonds and TIPS of different maturity lengths. Assume that all of the bonds have the same coupon rate:  

Bond #	Type	Maturity Length	Yield (%)
1	Treasury Note	10-Year	4.05
2	Treasury Bond	20-Year	5.35
3	TIPS	10-Year	2.05
4	TIPS	20-Year	2.85

Based on the information in the table, we can assume that traders in the TIPS market expect that the annual average inflation rate will be _____ percent over the next 20 years.

Select one:

a. 3.30

b. 1.30

c. 2.50

d. 2.00

e. 0.85

f. 1.20

Answer 1

Answer

Option c) is correct. 2.50

Reason:

Treasury bonds (T-bonds) are government debt securities issued by the federal government that have maturities greater than 10 years. They are regarded as virtually risk-free since they are backed by the U.S. government's ability to tax.

The 20 year Treasury Bond gives a fixed yield of 5.35%. However, TIPS gives a yield of 2.85% for the same time period. Thus, the average inflation rate expected by traders in TIPS market is (5.35 - 2.85) = 2.50% over next 20 years.