IAI Actuarial Core Principles · Actuarial Mathematics for Modelling · Allowing for inflation
An investor buys an index-linked bond whose payments are linked to an index with no lag. Which statement about the real yield is correct if actual inflation turns out higher than the market's implied inflation at purchase?
The realised real yield is unchanged. Because an index-linked bond's payments rise with the price index, its real cash flows are fixed, so higher inflation increases the money yield but leaves the real yield the same.
- AThe realised real yield is unchanged, because payments rise with the indexCorrect
- BThe realised real yield is lower, because coupons are fixed in money terms
- CThe realised money yield is lower than expected
- DThe realised real yield is higher, because the bond is overpriced
- The bond defaults
Explanation
Payments scale with the index, so real cash flows are fixed regardless of inflation. The real yield is therefore unchanged, while the money yield rises with higher inflation. The other options reverse this effect.
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