Question

Copii Tomework How does inflation impact returns? In this example, you will see how the Fisher equation can be used to determine the best investment option Suppose Jim has $2,000 to invest and he is not sure what will happen to inflation over the coming year, but the overall market expectation is for inflation to be around 3%. Jim is still uncertain, but he decides to hedge his bets and buy a $1,000 one-year bond paying a 4% annual coupon rate (Bond A). He puts the other $1,000 into a different one-year bond that is indexed to inflation that pays a 1% coupon rate plus an inflation premium that is linked to the consumer price index (Bond B). At the end of the year, the CPI shows that inflation was actually 5% for the year. How did Jim fare with his investments Questions to pose: 1. Calculate the end of year value of Jim's two distinct investments assuming both mature at year end. 2. Which investment generated the highest return? 3. What do these results indicate about investor expectations? Submission status No attempt Submission status 647 PM @ A A 7/12/2019

Answer 1

Answers Given that ; Jems Inverted Tom Anvel Lol = $2000 inflation = 37. One year Band - $1000 Annual Coupon realē 24% Different one yecer bond - $1000 dosflation that pays coupon rate = 1 De cpi shows Inflation for year = 5% me line distinct investim O Calculate end of year value of gins liv boing mature at year end? -enti asilimine on mature at year $1000 Coupon rate one year bond paying a woh annual adt (Bond A) End of year value of Band A i - 1000 X 104 $1040 $2000 different one year bond paying Is coupon rate plus at (Band B) Band Bi End of year value of Andexed * 1000 x 1105 x 101 1060.51 Sin the case of Anflation indexed bonds, the principal will be

a adjusted for Anflation. 80 Read worth of money is protected Hence procipal will become y l00px1.05 3 lost and Interest of th will be calculated in this inflation adjusted principale na highest return) @ which Investment generated highest resturm with anflation rate Investment 2 generated and its pays the above inflatus. was 5%. :CPL in last year . Investment 2.generated as 18+5% e s 6"/. of nominal letum. S memoled o 14+5%. at detur 4. Petums generated cohere as investment B 2 option, is a better bere fore Investment expectations, what do these results indicate about Investă Le bought by the Investor, that means a higher Inflation rate in be He is expecting expectation is low. Buying Band I means, inflation Inflation rate in future.