Question

10. A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate circumstances, expected inflation rises from 2 percent to 3 percent. (L04) a. Assuming the nominal yield rises by an amount equal to the rise in expected inflation, compute the change in the price of the bond. b. Suppose that expected inflation is still 2 percent, but the probability that it will move to 3 percent has risen. Describe the consequences for the price of the bond.

Answer 1

a) Bond price when inflation is 2% yield is 6%: 100/1.06^10 = 55.84;

Bond price when inflation is 3% yield is 7%: 100/1.07^10 = 50.83

b) With a rise in inflation, corrodes the purchasing power and makes the same basket of goods more costly in comparison to the time when the prices were relatively less. Consequently, the needs of investor need to be compensated. In the given situation as there is a rise in the inflation risk, thus investors will require compensation for taking on extra risk, thus price will decline and the yield will rise