Prudence buys a bond in EUR when it issued by the French government and inflation linked. It offers a 2% yearly coupon. She holds it for five years.
Par value: EUR 10,000
Price paid: EUR 10,100
Coupon paid yearly at the end of the year
Inflation: Year 1 2%
Year 2 3%
Year 3 1%
Year 4 1%
Year 5 2%
The coupon is reinvested each year at 1% compounded yearly.
At the end of the five years, how many EUR does Prudence have?
What is her average annual yield (or rate of return)?
What was the total price increase (i.e. increase in the CPI) over the five years?
By what percent has her purchasing power increased with the bond money over the five years.
HINT: the effective par value is increased by the inflation each year. Assume the coupon is paid as a function of the (adjusted) par value of the bond at the end of the same year, and that after five years the full adjusted par value is paid plus, of course, the last coupon.