Final answer:
A tips bond is a type of bond that is adjusted for inflation. The yield on the bond can be calculated by considering the interest payments and any capital gains. When interest rates rise, bonds previously issued at lower interest rates will sell for less than face value, and when interest rates fall, bonds issued at higher interest rates will sell for more than face value.
Step-by-step explanation:
A tips (inflation-indexed) bond is a type of bond that is adjusted for inflation. In this example, the bond has a 2-year maturity and a real coupon of 5.8% paid annually. If you buy the bond at its face value of $1,000 and the inflation rate is 10.70% in each year, you can calculate the yield on the bond.
To calculate the yield, you need to consider the interest payments and any capital gains. In this case, the investor will receive the $1,000 face value plus $80 for the last year's interest payment. The yield on the bond is then calculated as ($1080 - $964)/$964 = 12%.
It's important to note that when interest rates rise, bonds previously issued at lower interest rates will sell for less than face value. Conversely, when interest rates fall, bonds previously issued at higher interest rates will sell for more than face value.