Question

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?

a. Conventional 1-year bank CD

b. 1-year “Inflation-Plus” CD

b. Can you tell which offers the higher expected return?

a. Expected rate of inflation

b. Bank rate

c. Cannot be determined

c. If you expect the rate of inflation to be 3% over the next year, which is the better investment?

a. Conventional CD

b. “Inflation-Plus” CD

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?

a. Yes

b. No

Answer 1

Ans. =

A)

(Option B) 1-year “Inflation-Plus” CD

As we don't know about the Inflation Rate that would be in the Economy in 1 year.

So, if Rate of Inflation is more than 3.5 then we should accept 1-year “Inflation-Plus” CD.

Otherwise, if Rate of Inflation is lesser than 3.5% then we should go for 1 yr. Bank CD.

So, Based on the Current Available Information, we should go for 1-year “Inflation-Plus” CD as we don't know about the Inflation, it may be more or less than 3.5%.

So, it would be safer to invest in 1-year “Inflation-Plus” CD.

B)

(Option C) Cannot be determined

As we don't have the information on Inflation Rate, we can't say which investment would offer Higher Return.

as other Risks premiums are also constant, means they have same maturity, same liquidity, etc.

C)

(Option A) 1-Year Bank CD would be benificial.

If the Rate of inflation to be 3%, then (Option A) 1-Year Bank CD would be benificial.

as 1 year Bank CD Returns (5%) would be Higher than 1-year “Inflation-Plus” CD Return (1.5% + 3%) = 4.5%

D)

Yes, Market’s expected rate of inflation is 3.5%.

Risk-free nominal interest rate of 5% per year.
Risk-free real rate of 1.5%.

Nominal Risk-free Interest Rate = Real Risk free Interest Rate + Expected Inflation Rate

5% = 1.5% + Expected Inflation Rate

Expected Inflation Rate = 5% - 1.5%

Expected Inflation Rate = 3.5%

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