Question

Suppose a 10-year TIPS bond with an original principal of $100,000 and 4 percent coupon rate paid semiannually. If the inflation rate for first and second six-month period is 0.5 percent, and then the inflation rate becomes 1 percent for every six months until the end of maturity. What is the coupon payment at the end of second year?

Select one:

a. $2,060.65

b. $2,102.07

c. $2,144.32

d. $2,187.42

e. None of the above

Answer 1

Solution:

TIPS bonds stand for Treasury Inflation-Protected Security is a bond whose principal is adjusted for inflation & deflation and accordingly, the investor is protected from inflation.The principal amount rises as inflation rises & decreases as inflation falls.The coupon amount is calculated on the adjusted principal amount.

Hence

Adjusted principal at end of 2nd year = $1,00,000 * 1.005 * 1.005 * 1.01 * 1.01

= $ 1,03,032.65

Coupons are paid semiannually i.e 2% per period

Coupon payment at end of 2nd year = $ 1,03,032.65 * 2%

= $ 2060.65