Question

Tom chooses to invest $10,000 in 10-year, fixed-rate U.S. Treasury bonds with a coupon of 2.625 instead of in 10-year TIPS with a coupon of 1.250. Tom expects the inflation rate to be 3% on average over the lives of the bonds. Why is his decision to invest in fixed-rate U.S. Treasury bonds inconsistent with his expectations of the inflation rate?

Answer 1

The Answer Choices for this question are

A.

Tom's expected inflation means the TIPS will be more valuable in real terms.

B.

Tom's expected inflation means that the TIPS will be less likely to default.

C.

Tom should have added 3% to the coupon of the fixed-rate bonds because of inflation.

D.

Tom should have changed the maturity dates of the fixed-rate bonds because of inflation.

And of these choices i believe the answer is A

Answer 2

To answer the question above as to why tom decided to invest in a fixed-rate with Treasury bond coupon of 2.624% and TIPS coupon of 1.250 is in the question itself. knowing that the inflation rate is 3% on average over the lives of the bonds, Tom projected already that he is safe with 0.875% gain yearly to his investment. To get the bond vs inflation.. just simply add the T-bond coupon and TIPS minus the inflation rate.