Reference no: EM131354446

Consider a four-year inflation indexed bond. The bond indexes the par value to inflation, such that it increases based on realized inflation over the year. The bond pays fixed annual coupon payments of 4.5% of the modified par value as well as the modified par value at maturity. You have the following expectations for inflation over the life of the bond. Year Expected inflation 1 2% 2 3% 3 1% 4 1% a) If 4.5% represents the required return on the bond (the yield to maturity), given your expectations for inflation, what should you be willing to pay for this bond today? b) You plan to sell the bond one year from today. You will receive one coupon prior to selling. What is your expected return? c) One year from today, after you receive the first coupon payment, actual inflation for year 1 is reported to be 3% rather than 2%. As a result of this new information, you revise your inflation expectations as outlined in the table below. The required return remains the same. Given these expectations, what price would you be willing to sell the bond for a year from today? If you sell at this price, what is your actual on year return? Year Expected inflation 2 4% 3 2.5% 4 2%. Suppose that following the announcement of actual inflation the prices on the bonds fall. According to the EMH, what does this say about the market’s expectations for inflation? How did they compare to your own?