Question

Suppose the real interest rate is 2.8%, and the inflation rate is 7%. (1) How much do you need to invest now in order to get $100 in a year? Please show two approaches to calculate the answers. (Round your final answer to two decimal places) (2) Suppose the U.S. Treasury issues 5% coupon, 3-year TIPS (Treasury Inflation-Protected Securities). What are the real cash flows on the 3-year TIPS each year? What are the nominal cash flows on the 3-years TIPS each year? (Round your final answers to two decimal places)

Answer 1

Answer1. Real Interest Rate Inflation-Adjusted (2.8% x 7%) Internal Rate of Return (IRR) 2.80% + 0.20% 2.80% 0.20% 3.00% Present Investment to get $100 in a year will be = ($100 x (PVIF for 1 year @ 3% Present Investment to get $100 in a year will be = (100 x 0.9708) = $97.08 Answer2. Suppose face value of bond is $100 Annual Interest ($100 x 5%) = $5 Third year cash flow includes maturity $(5 + 100) = $105 Year Cashflow PVIF @ 5% (a) (b) (c) 1 5 0.952 2 5 0.907 3 105 0.864 Real Cash Flow 100 Present Value (d = b x C) 4.761905 4.535147 90.70295 Answer2. Year Cash-Flow (a) (b) 1 5 2 5 3 105 Nominal Cash Flow 115

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