Question

Suppose that the coupon rate for a TIPS is 5%. Suppose further that an investor purchases $20,000 of par value (initial principal) of this issue today and that the annual inflation rate is 3.5%.

(1) What is the inflation-adjusted principal at the end of the first six months? (2.5 point)

(2) What is the dollar coupon interest that will be paid in cash at the end of the first six months? (2.5 point)

(3) What is the inflation-adjusted principal at the end of the first year one? (2.5 point)

(4) What is the dollar coupon interest that will be paid in cash at the end of year one? (2.5 point)

Answer 1

1. Inflation Adjusted Principal at the end of first 6 month = $20,000 * (Square root of 1.035) = $20,000 * 1.01735 = $ 20,347. (Assumng Compound Interest Scenario)

2. Dollar coupon interest that will be paid in cash at the end of the first six months = $ 20,347 * 2.5% = $ 508.68.

3. Inflation-adjusted Principal at the end of the first year one = $20,000 * 1.035 = $ 20,700.

4. Dollar coupon interest that will be paid in cash at the end of year one = $ 20,700 * 5% = $ 1,035.