You want to make a one-year investment in a fixed-income security. You have three

investment choices. The first is a Treasury security with a nominal interest rate of 3%, the

second is a municipal security with a nominal rate of 2.5%, and the third is a Treasury inflation protected security (TIPS), which promises a real interest rate of 0.5%. (Assume that the coupon is paid only once at the end of the year, that the securities trade currently at par and that they will pay back the face value at the end of the year.)

Nominal interest income from Treasury securities is taxed at the marginal income tax rate, and interest income from municipal securities is tax-exempt. Let's assume that inflation during the next year will be 2%.

a. Compute for each of the three assets the nominal return before taxes.

b. The marginal tax rate on interest from Treasury securities is 35%. Interest on municipal

securities is tax exempt. Compute the nominal return after taxes for the three securities.

c. Compute for each of the three assets the real return after taxes.

d. Which investment should the investor undertake? Does the optimal investment depend

on the investor's risk aversion?