Question

You just buy a TIPS (Treasury Inflation-Protected Securities) which is inflation-indexed, has a face value of $1,000, 4% coupon rate, and a maturity of 3 years. Suppose for the following three years the inflation rate is 3%, 4%, and 5%, respectively. 1) What is your real cash flow in your holding period. 2) What is your nominal cash flow in your holding period. 3) What is the real return of the such investment in TIPS, suppose the selling price is $1,000 4) What is the nominal return of the investment, suppose that the selling price of the bond is quoted at 110

Answer 1

1) Real cash flow means cash flows after adjusting inflation

Year. CF. Inflation. Discounted cash flow

1. 40. 3%. 38.83

2. 40. 4%. 37.34

3. 40. 5%. 35.56

Total discounted cash flow = $111.73

2) Nominal cash flow means the cash flow without adjusting any inflation = 40+40+40 = $120

3) Real return on investment = Closing Inflow + Discounted inflow - Initial cash outflow/Initial cash outflow

= 1000+111.73-1000/1000 = 11.17 %

4) Nominal return on investment = 1100+120-1000/1000

= 22%