Suppose you desire a real return of 1 per year and you expec

Suppose you desire a real return of 1% per year and you expect the ination rate to be 1.5% per year. What annual nominal interest rate would you be willing to lend at? Use this interest rate to nd the most you would be willing to pay for a zero-coupon bond with face value $100 and a maturity date of 20 years.

Solution

(a)

Nominal return = Real return + Inflation rate

= 1% + 1.5%

= 2.5%

(b)

Present value (maximum price) of the zero-coupon bond = $100 / (1.025)²⁰

= $100 / 1.6386