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CHAPTER 5: LEARNING ABOUT RETURN AND RISK FROM THE HISTORICAL RECORD 1. a. The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing power of the investment. Using the approximation that the real rate equals the nominal rate minus the inflation rate, the CD provides a real rate of 3.5% regardless of the inflation rate. b. The expected return depends on the expected rate of inflation over the next year. If the expected rate of inflation is less than 3.5% then the conventional CD offers a higher real return than the Inflation-Plus CD; if the expected rate of inflation is greater than 3.5%, then the opposite is true. c. If you expect the rate of inflation to be 3% over the next year, then the conventional CD offers you an expected real rate of return of 4%, which is 0.5% higher than the real rate on the inflation-protected CD. But unless you know that inflation will be 3% with certainty, the conventional CD is also riskier. The question of which is the better investment then depends on your attitude towards risk versus return. You might choose to diversify and invest part of your funds in each. d. No. We cannot assume that the entire difference between the risk-free nominal rate (on conventional CDs) of 7% and the real risk-free rate (on inflation-protected CDs) of 3.5% is the expected rate of inflation. Part of the difference is probably a risk premium associated with the uncertainty surrounding the real rate of return on the conventional CDs. This implies that the expected rate of inflation is less than 3.5% per year. From Table 5.3, the average risk premium for large-capitalization U.S. stocks for the period 1926-2005 was: (12.15% ( 3.75%) = 8.40% per year Adding 8.40% to the 6% risk-free interest rate, the expected annual HPR for the SP 500 stock portfolio is: 6.00% + 8.40% = 14.40% 3. Probability distribution of price and one-year holding period return for a 30-year German Government bond (which will have 29 years