You bought one of Bergen Manufacturing Co.’s 6.2 percent coupon bonds one year a

Question

You bought one of Bergen Manufacturing Co.’s 6.2 percent coupon bonds one year ago for $1,038. These bonds make annual payments and mature fifteen years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 6 percent.

If the inflation rate was 2.4 percent over the past year, what would be your total real return on the investment?

You bought one of Bergen Manufacturing Co.’s 6.2 percent coupon bonds one year ago for $1,038. These bonds make annual payments and mature fifteen years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 6 percent.

Explanation / Answer

Current bond price can be calculated using PV function

N = 15, PMT = 6.2% x 1000 = 62, FV = 1000, I/Y = 6%

=> Compute PV = $1,019.42

Nominal Rate = (P1 + C - P0) / P0 = (1019.42 + 62 - 1038) / 1038 = 4.18%

Real Rate = Nominal Rate - Inflation = 4.18% - 2.4% = 1.78% using arithmetic formula

or using geometric method, real rate = (1 + 4.18%) / (1 + 2.4%) - 1 = 1.74%

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