You would like to invest $20,000 for a year in a risk-free investment. A convent

Question

You would like to invest $20,000 for a year in a risk-free investment. A conventional CD offers a 4.6% annual rate of return. You are also considering an “Inflation-Plus” CD which offers a real rate of return of 2.2% regardless of the inflation rate.

You decide to invest $10,000 in the conventional and $10,000 in the “Inflation-Plus” CD. What is your expected dollar value at the end of the year?

You would like to invest $20,000 for a year in a risk-free investment. A conventional CD offers a 4.6% annual rate of return. You are also considering an “Inflation-Plus” CD which offers a real rate of return of 2.2% regardless of the inflation rate.

Explanation / Answer

a) Implied inflation rate can be calculated by the following method :

( 1 + Inflation rate ) = ( 1 + risk free rate ) / (1 + Real Rate)

In this case (1 + Inflation rate) = (1+4.6%)/(1+2.2%) = 1.02348

There fore Inflation rate = 1.02348 - 1 = 0.2348 = 2.34% ..... Answer.

b) Return from Risk free security = 10,000 x (1 + 4.6%) = $10,460

Return from Inflation plus CD = 10,000 x (1 + 2.2%) X (1 + 2.34%) = $10,460.

So, the expected dollar value will be the sum of both the return. i,e 10460+10460 = $20,920. ..... Answer.

c) Since the implied inflation rate is 2.346% & and the actual rate is 2.2%, the inflation plus return will only generate (1+2.2%)x(1+2.2%) - 1 = 4.448%, and hece it will generate less than the risk free investment which will generate a return of 4.6%(given).

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