Question

Suppose that you buy a two-year 8.6% bond at its face value.

a-1. What will be your total nominal return over the two years if inflation is 3.6% in the first year and 5.6% in the second? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Nominal return             %

a-2. What will be your real return? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Real return             %

b. Now suppose that the bond is a TIPS. What will be your total 2-year real and nominal returns? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

Real return	%
Nominal return	%

Answer 1

A & B

IF INFLATION IS 3.6%

REAL RATE OF RETURN = COUPON RATE -INFALTION RATE / 1+ INFLATION RATE

Ist year rate of return =

real rate of return = 0.086 -0.036 / 1+ 0.036 = 0.048 or 4.8%

( 1 + nominal rate ) = ( 1 + real rate ) x ( 1 + inflation rate )

= (1 + 0.048 ) x ( 1 + 0.036)

= (1.048) x (1.036)

=1.08573

nominal rate = 1.08573 - 1

=0.085 or 8.5%

IF INFLATION IS 5.6%

REAL RATE OF RETURN = (0.086 - 0.056) / 1.056 = 0.028 or 2.8%

1 + NOMINAL RATE = (1+ REAL RATE ) x (1 + INFALTION RATE)

= ( 1 + 0.028 ) x ( 1 +0.056)
= ( 1.028) x (1.056)

1 + NOMINAL RATE = 1.08556

NOMINAL RATE = 8.5%

c)

TIPS = TRESURY INFLATED PROTECTED SECURITY

1st year

REAL RATE = COUPON RATE - INFLATION RATE

=0.086 - 0.036

=0.05

1 + NOMINAL RETURN = (1+REAL RETURN ) x ( 1+ INFLATION RATE)

= (1 +0.05) x (1 + 0.036)

=1.0878

NOMIBAL RATE = 1.0878 -1

NOMINAL RATE = 0.0878 or 8.78%

2nd year

REAL RETURN = COUPON RATE - INFLATION RATE

= 0.086 - 0.056

=0.03

1 + NOMINAL RETURN = (1+ REAL RETURN ) x ( 1+ INFALTION)

= ( 1 + 0.03) x ( 1 + 0.056)

= (1.03) x (1.056)

=1.08768

NOMINAL RETURN = 1.08768 - 1

= 8.78%