If the yield to maturity for a par value inflation-indexed bond with 8 years to maturity is 3%, and the yield to maturity of a Canadian Treasury note with 8 years is 4.25%, this implies that
A) The expected annual rate of inflation over the next 8 years is -1.25%.
B) The expected annual rate of inflation over the next 8 years is 1.25%.
C) The expected annual rate of inflation over the next 8 years is -2.25%
D) The expected annual rate of inflation over the next 8 years is 2.25%
E) None of the above.

Question

Quizplus · Accepted Answer

The difference between the yield to maturity of the nominal bond and the yield to maturity of the inflation-indexed bond is the breakeven inflation rate. In this case, it is 4.25% - 3% = 1.25%. This means that for the investor to be indifferent between investing in the nominal bond and the inflation-indexed bond, the annual rate of inflation over the next 8 years needs to be 1.25%. Therefore, the expected annual rate of inflation over the next 8 years is 1.25%.

If the Yield to Maturity for a Par Value Inflation-Indexed