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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?

    © BrainMass Inc. brainmass.com December 24, 2021, 7:07 pm ad1c9bdddf
    https://brainmass.com/business/interest-rates/real-nominal-interest-rates-164809

    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.

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    © BrainMass Inc. brainmass.com December 24, 2021, 7:07 pm ad1c9bdddf>
    https://brainmass.com/business/interest-rates/real-nominal-interest-rates-164809

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