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.

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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 4%, 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.
No.
We cannot assume that the entire difference between the risk-free
nominal rate (on conventional CDs) of 7% and the real risk-free rate (on
inflation-protected CDs) of 3.5% is the expected rate of inflation.
Part of the
difference is probably a risk premium associated with the uncertainty
surrounding the real rate of return on the conventional CDs.
This implies that
the expected rate of inflation is less than 3.5% per year.
4.
E(r) = [0.35
×
44.5%] + [0.30
×
14.0%] + [0.35
×
(–16.5%)] = 14%
σ
2
= [0.35
×
(44.5 – 14)
2
] + [0.30
×
(14 – 14)
2
] + [0.35
×
(–16.5 – 14)
2
] = 630
σ
= 25.52%
The mean is unchanged, but the standard deviation has increased, as the
probabilities of the high and low returns have increased.
5.
Probability distribution of price and one-year holding period return for a 30-year
U.S. Treasury bond (which will have 29 years to maturity at year’s end):
Economy
Probability
YTM
Price
Capital
Gain
Coupon
Interest
HPR
Boom
0.20
11.0%
$
74.05
−
$25.95
$8.00
−
17.95%
Normal Growth
0.50
8.0%
$100.00
$
0.00
$8.00
8.00%
Recession
0.30
7.0%
$112.28 $12.28
$8.00
20.28%
6.
From Table 5.3, the average risk premium for large-capitalization U.S. stocks for
the period 1926-2005 was: (12.15%

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