Question

This morning, you purchased a TIPS. Which one of these should you expect to occur if you hold this bond during an inflationary period?

O The coupon payment will increase in real terms.

O The maturity value will increase in nominal terms.

O The market price will remain constant at par.

O The market price will decrease.

Answer 1

If you hold a TIPS during an inflationary period, its maturity value will increase in nominal terms due to the inflation adjustment to the principal, resulting in increased coupon payments in real terms. However, market prices of TIPS can decrease if interest rates rise. Expected currency appreciation typically decreases bond yields due to increasing demand.

Step-by-step explanation:

If you purchased a Treasury Inflation-Protected Security (TIPS) this morning and hold it during an inflationary period, you should expect the maturity value to increase in nominal terms. TIPS are designed to protect investors from inflation by adjusting the principal value of the bond with inflation. When inflation rises, the principal amount of the TIPS increases, and since the coupon payment is a fixed percentage of the principal, the coupon payment in real terms will also increase.

However, it's important to understand that the market price of TIPS is not guaranteed to stay constant. Bond prices generally move inversely to interest rates. When interest rates rise, the market price of existing bonds, including TIPS, tends to fall. This is because new bonds are being issued at the higher current interest rates, making the older, lower-yielding bonds less attractive, hence their market price decreases. Conversely, if interest rates fall, the market price of existing bonds tends to rise.

Regarding the impact of expected exchange rates on yields, if a country's currency is expected to appreciate, this typically leads to lower yields on government bonds. The appreciation expectation increases the demand for that country's bonds as investors anticipate gains from the currency appreciation. In turn, this higher demand can lead to lower yields as prices for those bonds rise.

Answer 2

If you hold a TIPS during an inflationary period, the maturity value will increase in nominal terms to maintain its value against inflation. However, the market price may still be subject to interest rate risk and can fluctuate accordingly. The correct option is, 'The maturity value will increase in nominal terms.'

Step-by-step explanation:

When you purchase a Treasury Inflation-Protected Security (TIPS), during an inflationary period, you should expect certain impacts on the investment's performance. Unlike conventional bonds, TIPS provide protection against inflation. The principal amount of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). In an inflationary environment, the coupon payment, which is a percentage of the principal, will also increase in nominal terms. However, because this increase is meant to maintain the bond’s real value, the coupon payment will not necessarily increase in real terms but will keep pace with inflation.

With the increase in the CPI, the maturity value of the TIPS will increase in nominal terms. This means that when the bond matures, the investor will receive the adjusted principal or original principal, whichever is greater. These adjustments protect investors from the eroding effect of inflation on their investment. However, it's important to note that the market price of TIPS can fluctuate. While TIPS are designed to adjust for inflation, they are still subject to interest rate risk. If interest rates rise, the present value of the bond's future payments discounted at the new, higher interest rates will be lower, and hence the market value of the bond might decrease as investors demand a higher yield for taking on the risk of falling prices.

Therefore, if you hold a TIPS during an inflationary period, do not expect the market price to remain constant at par or for the coupon payments to increase in real terms. The correct option is, 'The maturity value will increase in nominal terms.'