Suppose that the inflation rate is currently 5% and that most investors believe

Question

Suppose that the inflation rate is currently 5% and that most investors believe that inflation will remain at this level indefinitely. You are convinced, however, that the inflation will decline to 2% or less in less than 5 years. Should you buy a 5-year Treasury bond or a 5-year TIPS today? (Hint: you should first of all figure out which bond will possibly give you higher value (price) in the future. Then, use the relation between bond yield (interest rate) and bond price to figure out about the future price.)

Explanation / Answer

If one believes that inflation rate would decline to 2% then the prevailing interest rate would also decline as a result. A decline in interest rate would drive up the price of a normal treasury bond (price is inversely related to interest rate). Therefore, one should opt for a 5 year Treasury bond. (In case of TIPS coupon payments would also decline with fall in inflation rate)

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.