Chapter 11: Real rates of return and index-linked bonds

Question 1

index-linked bonds

Answer 1

Each coupon payment depends on the rate of inflation in the economy

Question 2

RPI/CPI

Answer 2

Retail/Consumer Price Index
Way to measure inflation, uses a basket of goods (and services) over time by combining over 180000 individual prices for over 650 representative items.
They use different baskets and different formulae

Question 3

What does inflation do?

Answer 3

Erodes the purchasing power of money over time
i.e. if the price of goods increasing over time, the amount that a fixed sum of money can buy decreases

Question 4

Money rate of return

Answer 4

the percentage increase in money by investing.

e.g. if 1000 is invested at time 0 and 1050 is the total at time 1, the money RoR on the investment is 5% pa

Question 5

Real rate of return

Answer 5

Return % on investment taking into account inflation

1+i_r=(1+i)/(1+j)

where j is inflation and i is money ror

Question 6

Relationship between monetary cashflows and real cashflows

Answer 6

Assuming a constant rate of inflation of j pa effective:
Monetary cashflow at time t = Real cashflow at time t * (1+j)^t

Question 7

Calculating real cashflows at time 0 prices using an inflation index

Answer 7

Real cf at time t= Monetary cf at time t * inflation index at time 0 / inflation index at time t

Question 8

nominal coupon rate (for a bond)/ redemption rate

Answer 8

Coupon rate before indexation is applied

i.e. coupon rate under an assumption of zero inflation
Similarly for redemption rate