Question

If the yield to maturity for a par value TIPS bond with eight years to maturity is 3 percent, and the yield to maturity of a U.S Treasury note with 8 years is 4.25 percent, this implies that:

Group of answer choices
a. the expected annual rate of inflation over the next eight years is -1.25 percent.
b. the expected annual rate of inflation over the next eight years is 1.25 percent.
c. the expected annual rate of inflation over the next eight years is -2.25 percent.
d. the expected annual rate of inflation over the next eight years is 2.25 percent.
e. the expected annual rate of inflation over the next eight years is 0 percent.

Answer 1

The expected annual rate of inflation over the next eight years is estimated to be 1.25 percent, calculated by subtracting the TIPS yield from the nominal Treasury note yield.

Step-by-step explanation:

The expected annual rate of inflation over the next eight years is 1.25 percent. The yield to maturity (YTM) on a U.S Treasury note is typically higher than the yield on a Treasury Inflation-Protected Securities (TIPS) of the same maturity because TIPS compensate for inflation. Here, the nominal Treasury note has a YTM of 4.25 percent and the TIPS has a YTM of 3 percent.

To estimate the expected annual inflation rate, we subtract the TIPS yield from the nominal Treasury note yield: 4.25% - 3% = 1.25%. This suggests that investors expect an average annual inflation of 1.25 percent over the next eight years. The discrepancy between the two yields is often referred to as the inflation risk premium and reflects the compensation investors demand for the uncertainty of future inflation.

Understanding the relationship between TIPS and nominal Treasury securities is crucial for grasping how the bond market perceives future inflation and adjusting investment strategies accordingly.