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Homework answers / question archive / Suppose that you buy a two-year 7
Suppose that you buy a two-year 7.7% bond at its face value.
a-1) What will be your total nominal return over the two years if inflation is 2.7% in the first year and 4.7% in the second? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
a-2) What will be your total real return? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
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.)
a-1) Computation of the total nominal return over the two years:-
Total nominal return = (1+Coupon rate)^n -1
= (1+7.7%)^2 - 1
= 1.1599 - 1
= 15.99%
a-2) Computation of the real return over the two years:-
Real return = ((1+Coupon rate)/(1+1st year Inflation rate)) * ((1+Coupon rate)/(1+2nd year inflation rate)) -1
= ((1+7.7%)/(1+2.7%)) * ((1+7.7%)/(1+4.7%))-1
= (1.0487*1.0287)-1
= 1.0787 - 1
= 7.87%
b) The real return will remain at 7.87%
Computation of the total 2-year nominal returns:-
Nominal return over 2 years = ((1+Nominal rate)*(1+1st year Inflation rate)) * ((1+Nominal rate)*(1+2nd year inflation rate)) -1
= ((1+7.7%)*(1+2.7%)) * ((1+7.7%)*(1+4.7%)) -1
= (1.1061*1.1276)-1
= 1.2472-1
= 24.72%
