You want to make a one-year investment in a ï¬xed-incomesecurity. You have two investment choices: a Treasury security anda Treasury inflation-protected security (TIPS). The nominal interestrate for the Treasury security is 4% and TIPS promises 1% realinterest rate. You use scenario analysis to compare two securities.There are two possible scenarios with equal probabilities: Highinflation and low inflation. The inflation rate will be 0% in the lowstate and 6.1% in the high state. (Do not use % approximation byadding or subtracting)
(a) Compute nominal and real realized returns for eachasset with respect to each inflation scenario, and calculateexpected return of each asset. (Round to the nearesttenth)
Nominal Returns Before Taxes
| Low Inflation | High Inflation | Expected Return |
| Treasury Security | | | |
| TIPS | | | |
Real Returns Before Taxes
| Low Inflation | High Inflation | Expected Return |
| Treasury Security | | | |
| TIPS | | | |
b) According to (a), which security will investorschoose?
c) Now suppose the investor is subject to tax withmarginal tax rate 40%. Compute nominal and real realized returnsfor each asset with respect to each inflation scenario, andcalculate expected return of each asset. (Round to the nearesttenth)
Nominal Returns Before Taxes
| Low Inflation | High Inflation | Expected Return |
| Treasury Security | | | |
| TIPS | | | |
Real Returns After Taxes
| Low Inflation | High Inflation | Expected Return |
| Treasury Security | | | |
| TIPS | | | |
(d) What security would the investor choose if theinvestor has to pay tax with marginal tax rate 40%?
e) Explain why expected return and risk of TIPS changedafter taxes.
