Suppose that you buy a two-year 8.4% bond at its face value. a-1. What will be y

Question

Suppose that you buy a two-year 8.4% bond at its face value.

a-1. What will be your total nominal return over the two years if inflation is 3.4% in the first year and 5.4% 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? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

Real return %

Nominal return %

Explanation / Answer

1) Nominal return is the return which is not adjusted for inflation. So, in this case nominal return is 8.4% for both the years.

Total nominal return for 2 years = (1+ return rate)2 -1 = (1+0.084)2 -1 = 0.1750     OR      17.50%

2) Real return is the return which is adjusted for inflation.

Real return = (1+nominal return /1+inflation rate) - 1    OR      (nominal return - inflation rate)

when inflation is 3.4% => Real return = (1+ 0.084/1+0.034) - 1 = 0.0485    OR    4.85%

when inflation is 5.4% => Real return = (1+0.084/1+0.054) - 1= 0.0285     OR    2.85%

Total real return for 2 years = 4.85 + 2.85 = 7.70%

3) When bond is a TIPS( Treasury inflation-protected security) -

TIPS bonds pay fixed rate on the principle, but interest rate is adjusted for inflation to calculate the value of the principle.

So the return for the first year is 8.4% and for second year return rate is 10.4% {8.4+(5.4-3.4)} which is adjusted upward as inflation has increased.

Total nominal return for 2 years = 8.4 + 10.4 = 18.80%

Real return, 1st year = (1+0.084/1+0.034) - 1 = 0.0485     OR    4.85%

                    2nd year= (1+0.104/1+0.054) -1 = 0.0474     OR     4.74%

Total real return for 2 years = 4.85 + 4.74 = 9.59%

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