2039 Words9 Pages

CHAPTER 5: INTRODUCTION TO RISK, RETURN, AND THE

HISTORICAL RECORD

PROBLEM SETS

1.

The Fisher equation predicts that the nominal rate will equal the equilibrium real rate plus the expected inflation rate. Hence, if the inflation rate increases from 3% to 5% while there is no change in the real rate, then the nominal rate will increase by 2%. On the other hand, it is possible that an increase in the expected inflation rate would be accompanied by a change in the real rate of interest. While it is conceivable that the nominal interest rate could remain constant as the inflation rate increased, implying that the real rate decreased as inflation increased, this is not a likely scenario.

2.

If we assume that the distribution*…show more content…*

Open market purchases of U.S. Treasury securities by the Federal

Reserve Board are equivalent to an increase in the supply of funds (a shift of the supply curve to the right). The equilibrium real rate of interest will fall.

5-2

6.

The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing power of the investment. Using the approximation that the real rate equals the nominal rate minus the inflation rate, the CD provides a real rate of 1.5% regardless of the inflation rate.

b.

The expected return depends on the expected rate of inflation over the next year. If the expected rate of inflation is less than 3.5% then the conventional CD offers a higher real return than the Inflation-Plus CD; if the expected rate of inflation is greater than 3.5%, then the opposite is true.

c.

If you expect the rate of inflation to be 3% over the next year, then the conventional CD offers you an expected real rate of return of 2%, which is

0.5% higher than the real rate on the inflation-protected CD. But unless you know that inflation will be 3% with certainty, the conventional CD is also riskier. The question of which is the better investment then depends on your attitude towards risk versus return. You might choose to diversify and invest part of your funds in each.

d.

7.

a.

No. We cannot assume that the entire difference between the risk-free nominal rate (on conventional CDs) of 5% and the real risk-free rate

HISTORICAL RECORD

PROBLEM SETS

1.

The Fisher equation predicts that the nominal rate will equal the equilibrium real rate plus the expected inflation rate. Hence, if the inflation rate increases from 3% to 5% while there is no change in the real rate, then the nominal rate will increase by 2%. On the other hand, it is possible that an increase in the expected inflation rate would be accompanied by a change in the real rate of interest. While it is conceivable that the nominal interest rate could remain constant as the inflation rate increased, implying that the real rate decreased as inflation increased, this is not a likely scenario.

2.

If we assume that the distribution

Open market purchases of U.S. Treasury securities by the Federal

Reserve Board are equivalent to an increase in the supply of funds (a shift of the supply curve to the right). The equilibrium real rate of interest will fall.

5-2

6.

The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing power of the investment. Using the approximation that the real rate equals the nominal rate minus the inflation rate, the CD provides a real rate of 1.5% regardless of the inflation rate.

b.

The expected return depends on the expected rate of inflation over the next year. If the expected rate of inflation is less than 3.5% then the conventional CD offers a higher real return than the Inflation-Plus CD; if the expected rate of inflation is greater than 3.5%, then the opposite is true.

c.

If you expect the rate of inflation to be 3% over the next year, then the conventional CD offers you an expected real rate of return of 2%, which is

0.5% higher than the real rate on the inflation-protected CD. But unless you know that inflation will be 3% with certainty, the conventional CD is also riskier. The question of which is the better investment then depends on your attitude towards risk versus return. You might choose to diversify and invest part of your funds in each.

d.

7.

a.

No. We cannot assume that the entire difference between the risk-free nominal rate (on conventional CDs) of 5% and the real risk-free rate

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