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 10 years.

Select one:

a. 2.50

b. 1.20

c. 0.85

d. 1.30

e. 3.30

f. 2.00

Answer 1

Answer

Option f) is correct. 2.00

Reason:

Treasury bonds/ Notes (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 10 year Treasury Note gives a fixed yield of 4.05%. However, TIPS gives a yield of 2.05% for the same time period. Thus, the average inflation rate expected by traders in TIPS market is (4.05 - 2.05) = 2.00% over next 10 years.