1. Bond investors are likely to hold the view that the government guarantee on Federal bonds...

1. Bond investors are likely to hold the view that the government guarantee on Federal bonds means that the investor will get his investment back. He’s right about the assumption that the U.S. Treasury is extremely unlikely to default on their payments and therefore repayments carry close to 0 risks. But can we say the same when it comes to interest-rate and inflation risk? Explain fully.

Expert Solution

Answer :

In general federal bonds are risk free bonds .

Risk free bonds pays principal value and interest payment with absolute certinity .In theoretical there zero risk in risk free bonds but there is low probability of default risk and high probability of interest rate risk .

For the federal bond(risk free) holders government guarantee that the investment will be back .As compared to other type of bonds the default risk is very low because in this case the bond writer is central bank so the view or the assumption of the investor is acceptable .

But in case of interest rate risk there is high probability of ups and downs in interest payments because at the time of issue Treasury bonds interest rate is fixed but in the market the fed changes the interest rates time to time so in interest rates there is high probability of risk.

The concept of inflation also vests with the central bank ,mainly to control inflation central banks do their activities like changes in interest rates as we mentioned above how interest rates effects the Treasury bonds in the same way inflation also effects the Treasury bonds.

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