Fundamentals of Corporate Finance: Nominal vs Real cash flows
You are graduating in two years. You want to invest your current savings of $5,000 in bonds and use the proceeds to purchase a new car when you graduate and start to work. You can invest the money in either bond A, a two-year bond with a 3% annual interest rate, or bond B, an inflation-indexed two-year bond paying 1% real interest above the inflation rate (assume this bond makes annual interest payments). The inflation rate over the next 2 years is expected to be 1.5%. Assume that both bonds are default free and have the same market price. Which bond would you invest in? Please show complete solutions.