Question

Suppose that you buy a TIPS (inflation-indexed) bond with a 2-year maturity and a coupon of 5.3% paid annually. Assume you buy the bond at its face value of $1,000, and the inflation rate is 9.95% in each year. a. What will be your cash flow in year 1? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Cash flow T b. What will be your cash flow in year 2? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Cash flow c. What will be your real rate of return over the two-year period? (Enter your answer as a percent rounded to 1 decimal place.) Real rate of return %

Answer 1

a. For first year only coupon payment= 1000*5.3%

= 53$

b. Cash flow in year 2 = coupon+ Maturity value

= 53$+1000$

= 1053$

c. Real rate of return :- as per Fischer's effect real Interest rate can be calculated by following formula.

Real rate = ((1+Nominal rate)/(1+inflation rate))²-1

= (0.9577)²-1

=0.9172-1

= -0.0828

Real rate of return after 2 years= -8.28%