How does inflation impact returns? In this example, you will see how the Fisher equation can be used to determine the best investment option. Suppose Jim has $2,000 to invest and he is not sure what will happen to inflation over the coming year, but the overall market expectation is for inflation to be around 3%. Jim is still uncertain, but he decides to hedge his bets and buy a $1,000 one-year bond paying a 4% annual coupon rate (Bond A). He puts the other $1,000 into a different one-year bond that is indexed to inflation that pays a 1% coupon rate plus an inflation premium that is linked to the consumer price index (Bond B). At the end of the year, the CPI shows that inflation was actually 5% for the year. How did Jim fare with his investments?

Questions to pose:

1. Which investment generated the highest return?

2. What do these results indicate about investor expectations?