1. A one-year bond pays interest for $1,000 at the end of the year and the face value of $10,000/ Inflation during the year is expected to be 5%. The tax rate is 25%. Assume that the relevant nominal interest rate for this type of instrument is 10%.
a) Determine price of bond
b) Expected before-tax real interest rate of bond
c) Expected after-tax real interest rate of this bond
d) If inflation turned out to be 6%, what fraction of the (real) interest income was paid as taxes in real terms?
2. An inflation-protected bond promises to pay in real terms (constant dollars as opposed to nominal dollars) a total of $1,000 (in dollars with the purchasing power of year-0 dollars) at the end of each year during 3 years, as well as an inflation-protected amount that is currently (in year 0) at $20,000 at the end of the 3rd year. If the relevant nominal interest rate is 8% and inflation is expected to be 5% each year, determine the price of this bond. (Hint: either use the real present value formula or compute the inflation-protected amounts of each cash flow and then apply the usual present value formula.