2 ) Given the following data on yields of 10 year Treasury notes and 10 year TIP

Question

2) Given the following data on yields of 10 year Treasury notes and 10 year TIPS,(treasury inflation protection securities) what conclusion do you draw about:

a) Changes in investors` expectation of inflation rates in the US since spring 2012? Give a numerical answer if you can and in any case explain why you think the data indicate a rise or fall in inflation expectations.

b) Changes in the required yields on 10 year Treasuries. Explain your answer.

                           10 Year T-note yield             10 Year TIPS Yield

Spring 2012:       1.967%                                                 -0.255%

now                      2.23%                                                  0.46%

C) Other than linking TIPS future cash flows to the CPI, what other differences between 10 year TIPS and 10 year Treasuries could affect the difference in their yields? Explain

Explanation / Answer

a) Inflation exepcattion has risen because expected return on T note and TIPS has increased and inflation change is derived as below:

Inflation increase = (1.967% + .255%) - (2.23% - 0.46%) = 0.452%

b) Changes in required yield of 10 year treasuty securities will represent two component in it, one is change in real interest rate and another is inflation changes. Here total change in treasuries securities yield = 2.23% - 1.967% = 0.263%.

c) Other differences are:

1. TIPS yield changes based on actual inflation while Treasury securities yield changes based on expected inflation.

2. TIPS securities will calculate yield based on real interest and inflation is a guaranteed adjustment to return while treasury securities calculate yield absed on real interest plus expected inflation premium.

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