Question

Suppose an investor purchased a 10-year inflation-protected bond with a fixed annual real rate of 1.5% and another investor bought a 10-year bond without inflation protection with a nominal annual return of 4.2%. If inflation over the 10-year period averaged 2%, which investor earned a higher real return?

Select one:

a. Neither investor earned a positive real return.

b. The investor who purchased the inflation protected bond.

c. Both investors earned the same real return.

d. The investor who purchased the bond without inflation protection.

Answer 1

Investor 1:

Inflation-indexed bond with a fixed annual real rate of return = 1.5%

Investor 2:

The nominal annual rate of return = 4.2%

Average annual inflation rate = 2%

The real annual rate of return = Nominal annual rate of return - Average annual inflation rate = 4.2% - 2% = 2.2%

As the real rate of return for investor 2 is higher than that of investor 1, investor 2 earned a higher real return.

Ans: d. The investor who purchased the bond without inflation protection