Question

Suppose you bought a $1,000 face value bond with a coupon rate of 5.6 percent one year ago. The purchase price was $987.50. You sold the bond today for $994.20. If the inflation rate last year was 2.6 percent, what was your exact real rate of return on this investment?

Answer 1

Answer:

The real rate of return on this investment is 3.65%

Explanation:

For computing the real rate of return, we have to compute the nominal rate of return as it is not given in the question.

The formula to compute nominal rate of return is shown below:

= (Sale price - purchase price) + coupon ÷ (purchase price)

= ($994.20 - $987.50) + $56 ÷ ($987.50)

= ($62.70) ÷ ($987.50)

= 6.35%

The coupon = $1,000 × 5.6 = $56

Now we have to apply the formula for computing the real rate of return which is shown below:

Real rate of return = {( 1 + nominal rate of return) ÷ ( 1+ inflation rate)} - 1

                               = {(1 + 6.35%) ÷ ( 1 + 2.6%) - 1

                                = 1.0365 - 1

                                = 3.65%