Question
Suppose that the current inflation expectation for the next three years is 2%. There is a three-year inflation-adjusted bond that pays bondholders an interest rate
Suppose that the current inflation expectation for the next three years is 2%. There is a three-year inflation-adjusted bond that pays bondholders an interest rate equal to a fixed rate of 2% plus the rate of inflation, with coupon payments made semiannually. Suppose you purchase this bond and immediately after the purchase, a major scientific breakthrough was announced that could cut energy costs in half one year from now. In reaction, the inflation expectation for the next two year suddenly drops from 2% to 1%. What would be the bond price before and after the news is announced? Use the bond yield as the discount rate and assume that the bond par value is 100.
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