Final answer:
The returns of different asset classes react differently to inflation. Cash and bonds typically perform poorly when inflation is higher than expected but do better when inflation is below expectations option(a).
Step-by-step explanation:
The concern about asset class returns about inflation expectations can be addressed by looking at typical reactions of different assets when inflation is above or below expectations. When inflation is above expectations, cash and bonds typically experience lower returns due to the eroding purchasing power of the fixed returns they provide.
Similarly, the fixed income from bonds is less attractive when actual inflation is higher than what was expected when the bonds were issued. On the other hand, equity and real estate often perform better as they can sometimes act as a hedge against inflation, with companies raising prices and property values increasing.
Conversely, if inflation is lower than expectations, cash tends to have higher real value, and the fixed income from bonds is more attractive, leading to potentially higher returns for these assets. In the case of equities and real estate, lower-than-expected inflation can lead to lower returns as the impetus for price increases abates.
Therefore, the correct answer to the student's question regarding asset class returns when inflation is above or below expectations is: Above: Cash and bonds low, Equity and real estate high; Below: Cash and bonds high, Equity and real estate low. Thus, option A is the correct selection.