You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.
a. Which is the safer investment?
b. Which offers the higher expected return?
c. If you expect the rate of inflation to be 3% over the next year, which is the better investment? Why?
d. If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5% on inflation-indexed bonds, can we infer that the markets expected rate of inflation is 3.5% per year?