Question

Suppose that you buy a two-year 8% bond at its face value.

Answer 1

Answer:

Real Rate of Return = 4.9%  and Nominal rate = 0.08 or 8%

Real Rate of Return = 2.9%  and Nominal rate = 0.081 or 8.1%

real rate = 5 %   and Nominal rate = 0.0815 or 8.15%

real rate = 3%  and Nominal rate = 0.0815 or 8.15%

Step-by-step explanation:

given data

time period = 2 year

Coupon rate = 8% =  0.08

Inflation rate 1st year = 3% =  0.03

Inflation rate 2nd year = 5% =  0.05

solution

we get here Real Rate of Return  that is express as

Real Rate of Return = (Coupon Rate - Inflation rate) ÷ (1+Inflation rate)   .........1

so that here 1st year Real return  will be

Real Rate of Return = (0.08 - 0.03) ÷ (1+0.03)

solve it we get

Real Rate of Return = 4.9%

and

(1 + nominal rate) = (1 + real rate) × (1 + inflation rate)     ............2

(1 + nominal rate) = (1 + 0.049) × (1 + 0.03)

Nominal rate = 0.08 or 8%

and

for 2nd year Real return  will be

Real Rate of Return = (0.08 - 0.05) ÷ (1+0.05)

solve it

Real Rate of Return = 2.9%

and

(1 + nominal rate) = (1 + real rate) × (1 + inflation rate)     ............3

(1 + nominal rate) = (1 + 0.029) × (1 + 0.05)

Nominal rate = 0.081 or 8.1%

and

now for the bond Treasury Inflation-Protected Securities, we get real and nominal return that is

for 1st year

Real rate = Coupon rate - Inflation     ...............4

Real rate = 0.08 - 0.03

real rate = 0.05

and

(1 + nominal rate) = (1 + real rate) × (1 + inflation rate)     ................5

(1 + nominal rate) = (1 + 0.05) × (1 + 0.03)

so

Nominal rate = 0.0815 or 8.15%

and for 2nd years  it will be

Real rate = Coupon rate - Inflation      ....................6

Real rate = 0.08 - 0.05

real rate = 0.03

and

(1 + nominal rate) = (1 + real rate) × (1 + inflation rate)     ...................7

(1 + nominal rate) = (1 + 0.03) × (1 + 0.05)

so

Nominal rate = 0.0815 or 8.15%