Question

Suppose that you buy a 1 year maturity for $980 that will pay you $980 plus a coupon of $42 at the end of year.
a. What real rate of return will you earn if the inflation rate is 2.2 percent?
b. What real rate of return will you earn if the inflation rate is 4.2 percent?
c. What real rate of return will you earn if the inflation rate is 4.8 percent?
d. What real rate of return will you earn if the inflation rate is 7.8 percent?

Answer 1

Nominal rate of return, r = FV / PV - 1 = (980 + 42) / 980 - 1 = 4.29%

Real rate of return = (1 + r) / (1 + i) - 1 = (1 + 4.29%) / (1 + i) - 1

where i = inflation rate.

Part (a)

i = 2.2%

Real rate of return = (1 + 4.29%) / (1 + 2.2%) - 1 = 2.04%

Part (b)

i = 4.2%

Real rate of return = (1 + 4.29%) / (1 + 4.2%) - 1 = 0.08%

Part (c)

i = 4.8%

Real rate of return = (1 + 4.29%) / (1 + 4.8%) - 1 = -0.49%

Part (d)

i = 7.8%

Real rate of return = (1 + 4.29%) / (1 + 7.8%) - 1 = -3.26%