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# Real versus Nominal Interest Rates

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40. The interest rate on conventional 10-year Treasury bonds is 7% per year and the interest rate on 10-year TIPS (Treasury inflation-protected securities) is 3.5% per year. You have \$10,000 to invest in one of them.

a. If you expect the average inflation rate to be 4% per year, which bond offers the higher expected rate of return?

b. Which would you prefer to invest in?

## SOLUTION This solution is FREE courtesy of BrainMass!

a. In real terms, the expected rate of return on the nominal bonds is

(7% - 4%)/1.04 = 2.885%, which is less than the 3.5% offered by the TIPS.

Or, in other words, TIPS offer a higher expected nominal rate of return.

Expected nominal rate of return on TIPS = .035 +.04 + .035x.04 = .0764 or 7.64%.

This is higher than the 7% nominal return on conventional Treasury bonds.

b. Since they offer a higher expected return rate of return, you should invest in TIPS.

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