Question

You are considering the choice between investing $50,000 in a conventional 1-year bank CD
offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the
rate of inflation.
a. Which is the safer investment?
b. Can you tell which offers the higher expected return?
c. If you expect the rate of inflation to be 3% over the next year, which is the better investment? Why?
d. If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5% on
inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per year?

Answer 1

Part (a): Inflation -plus CD is safer investment because it takes care of inflation part, ensuring real rate of return constant.

Part (b): Without ascertaining the inflation rate, we cannot tell which method offers higher expected return

Part (c ): If the inflation is expected to be 3% over the next year, the inflation-plus CD will give interest at 1.5% + 3% = 4.5%. Hence the conventional One year CD offering 5% interest is better.

Part (d): Rough estimation of inflation using nominal rate and real rate is as flows:

Inflation= Nominal rate minus Real Rate

Given Nominal rate=5% and Real rate on inflation indexed bonds=1.5%

Therefore, approximate rate of inflation expected= 5% -1.5% = 3.5%

A more accurate calculation of inflation is as follows:

Inflation= [(1+N)/(1+R)]-1 Where N= Nominal rate and R= Real rate

Therefore, inflation expected= [(1+5%)/(1+1.5%)]-1 = (1.05/1.015)-1 = 0.034483 Or, 3.4483%