Question

You have some savings and you are considering three options for holding those savings. You face a choice of either:

(1) Putting your savings into an investment account that tracks the S&P 500. This has a rate of return at 10% per year.

(2)Putting your savings into buying government bonds that returns 5% after a year.

(3) keeping your money in cash under your mattress.

Inflation is at 3.22%. Even though we cannot forecast inflation perfectly assume that this will be the inflation rate over the next year. What is the real rate of return on all three investment ideas.

Answer Choices:

A. (1) 6.78%, (2) 1.78%, (3) -3.22%

B. Not enough information

C. (1) 13.22%, 8.22%, (3) 3.22%

D. (1) 10%, (2) 5%, (3) 0%

Answer 1

Ans) (A) 6.78%, 1.78%, -3.22%.

Reason: Real rate of return = Nominal rate - Rate of inflation

r = i -

1. i = 10%, = 3.22%, therefore, r = 10 - 3.22 = 6.78%

2. i = 5%, = 3.22%, therefore r = 5 - 3.22 = 1.78%

3. In this case, when the money is under your mattress it is not giving any percent of return to you hence, i = 0%

Therefore, r = 0 - 3.22 = -3.22%