CAS Exam 9 Spring 2017, Question 13
Study guide: Exam 9
Given the following newly issued 3-year inflation-indexed bond with $1,000 par value:
- The bond pays annual coupons at a coupon rate of 5%.
- The inflation rate is 1% throughout the first year and is expected to increase 100 basis points each year for the following two years.
- The principal is fully repaid at the end of year 3.
- Tax rate is 0%.
Part a (1.25 points)
Calculate the nominal return of the bond in the third year.
Part b (0.5 points)
Demonstrate that the inflation-indexed bond reduces return volatility.
Part c (0.5 points)
The asset manager of the portfolio is concerned about the risk associated with receiving the principal at the end of the bond's life. Describe a mechanism available to the bond issuer to reduce this risk.
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