Subject: Question regarding Exercise 4b - Week 3 "Stocks & Bonds" Lecture - Real Yield Calculation
Dear Julio,
I am reviewing Exercise 4 from Week 3's "Stocks & Bonds" lecture, specifically part b) concerning the real yield of the inflation-adjusted bond.
I'm a bit confused about the intermediate step in the lecture notes where the real yield (yr) seems to be calculated using the equation:
Pinf = 3 / (1 + yr) + 103 / (1 + yr)^2 = 95
and arriving at a real yield of approximately 5.7%.
My understanding is that for inflation-adjusted bonds, to calculate present value using a real discount rate, one should also be using real cash flows (i.e., cash flows already adjusted for inflation). However, in this equation, it appears we are discounting the nominal cash flows of the inflation-adjusted bond (3 and 103) with what is being solved for as the real yield (yr).
Could you please clarify the rationale behind this specific approach for calculating the real yield in the lecture notes for this exercise? Is there a particular interpretation or simplification being used here that I might be missing?
Thank you very much for your time and guidance.