Question

You are graduating in two years. You want to invest your current savings of $5,000 in bonds and use the proceeds to purchase a new car when you graduate and start to work. You can invest the money in either Bond A, a two-year bond with a 3 percent annual interest rate, or Bond B, an inflation-indexed two-year bond paying 1 percent real interest above the inflation rate (assume this bond makes annual interest payments). The inflation rate over the next two years is expected to be 1.5 percent. Assume that both bonds are default free and have the same market price. Which bond should you invest in?

Answer 1

Answer: Here you go

Explanation:

To compare the two bonds, we need to calculate the total return for each bond over the two-year period.

For Bond A:

Principal amount = $5,000

Annual interest rate = 3%

Time period = 2 years

Total interest earned = $5,000 x 3% x 2 = $300

Total return = Principal + Total interest = $5,000 + $300 = $5,300

For Bond B:

Principal amount = $5,000

Real interest rate = 1%

Inflation rate = 1.5%

Time period = 2 years

Total real interest earned = $5,000 x 1% x 2 = $100

Total inflation adjustment = $5,000 x 1.5% x 2 = $150

Total nominal interest earned = Total real interest + Total inflation adjustment = $100 + $150 = $250

Total return = Principal + Total nominal interest = $5,000 + $250 = $5,250

Therefore, based on the calculations, it appears that Bond A is the better choice since it has a higher total return than Bond B. However, it's important to note that Bond B provides inflation protection, which means that the real value of the investment will not be eroded by inflation over time. This may be an important consideration for long-term investments or investments that are exposed to high inflation rates.