Suppose that you buy a two-year 8.5% bond at its face value. a-1. What will be y

Question

Suppose that you buy a two-year 8.5% bond at its face value.

a-1. What will be your total nominal return over the two years if inflation is 3.5% in the first year and 5.5% 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?

Explanation / Answer

Ans:

1) Total nominal return for two years = nominal return for year 1 + nominal return for year 2

= 8.5% + 8.5%

= 17%

2) Total real return for two years = (nominal return for year 1 - inflation for year 1) + (nominal return for year 2 - inflation for year 2)

= (8.5% - 3.5%) + (8.5% - 5.5%)

= 5% + 3%

= 8%

3) Treasury Inflation-Protected Securities(TIPS) provide protection against inflation.

Total nominal return for two years = (nominal return for year 1 + inflation for year 1) + + (nominal return for year 2 + inflation for year 2)

= (8.5% + 3.5%) + (8.5% + 5.5%)

= 12% + 12%

= 24%

Total real return for two years = (real return for year 1 + inflation for year 1) + (real return for year 2 + inflation for year 2)

Total real return for two years = (5% + 3.5%) + (3% + 5.5%)

= 8.5% + 8.5%

= 17%

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