Question

You bought one of Great White Shark Repellant Co.’s 9 percent coupon bonds one year ago for $770. These bonds make annual payments and mature 14 years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 12 percent. If the inflation rate was 3.6 percent over the past year, what was your total real return on investment?

Answer 1

Answer :

Calculation of Total Real Return:

First, calculate the current bond price as

Current bond price = Coupon * [ 1 - { 1 / ( 1 + r )^n } / r ] + [ Face value / ( 1 + r )^n ]

= $ 90 * [ 1 - { 1 / ( 1 + 12% )^14 } / 12% ] + [ $ 1,000 / ( 1 + 12% )^14 ]

= $ 801.15

Now, calculate the normal rate of return as

Normal rate of return = [ Coupon + ( Current bond price - Bond price one year ago ) / Bond price one year ago ]

= [ $ 90 + ( $ 801.15 - $ 770 ) / $ 770 ]

= 15.73%

Therefore,

The Total Real Return = [ ( 1 + Nominal return ) / ( 1 + Inflation rate ) ] - 1

= [ ( 1 + 15.73% ) / ( 1 + 3.6% ) ] - 1

Total Real Return = 11.71%