Problem 10.16 You are graduating in two years. You want to invest your current s

Question

Problem 10.16 You are graduating in two years. You want to invest your current savings of $8,800 in bonds and use the proceeds to purchase a new car when you graduate and start to work. You can invest the money in either bond A, a two-year bond with a 3.34 percent annual interest rate, or bond B, an inflation-indexed two-year bond paying 1.09 percent real interest above the inflation rate (assume this bond makes annual interest payments). The inflation rate over the next two years is expected to be 1.55 percent. Assume that both bonds are default free and have the same market price. Which bond should you invest in? (Round answers to 2 decimal places, e.g. 15.25%) Nominal interest rate for Bond A Nominal interest rate for Bond B Invest in v Bond A Click if yo Bond B to Show Work for this question: Open Show Work

Explanation / Answer

All things remaining same, Bond - A which pays more nominal rate than B is selected as best investment.

For bond - A, the interest rate is directly given in the question.

For Bond - B the real interest rate = 1.09 and Inflation rate = 1.55 are given ....so we have by direct addition method, we have 1.09 + 1.55 = 2.64% It was specifed in the question that on and above the inflation so we used direct addition. Otherwise the correct approach is to use product method ..........i.e

Nominal rate = ( 1 + real rate ) (1 + inflation rate ) - 1

= (1.0109) ( 1.0155) - 1 = 2.65%

Nominal interest rate for Bond A 3.34 Nominal interest rate for Bond B 2.64 Invest in Bond -A

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