Question

The following questions are about Treasury Inflation Protected Securities (TIPS).

(a) What is meant by the “real rate”?

(b) What is meant by the “inflation-adjusted principal”?

(c) Suppose that the coupon rate for a TIPS is 3%. Suppose further that an investor purchases $10,000 of par value (initial principal) of this issue today and that the annual inflation rate is 2%.

Answer the below questions.
(1) What is the inflation-adjusted principal at the end of six months?

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

(d) Suppose that an investor buys a five-year TIP and there is deflation for the entire period. What is the principal that will be paid by the Department of the Treasury at the maturity date?

Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It has application not only in trading bonds, but also stocks, commodities, and other assets. Conduct your own research on arbitrage and elaborate on why it occurs and how traders can take advantage of it. Do arbitrage opportunities have short or long shelf life?

Note: Use one-page single space format. Internet research is encouraged (cite your sources), but your paper should be in your own words.

Answer 1

1. The real interest rate is the rate an investor or lender receives after allowing for inflation. It can also be described by the Fisher equation, which states that the real interest rate is nominal interest rate minus the inflation rate.

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate:

Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)

1. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate.
2. 1. Adjusted principal is 10,200. 2. 153 will be interest paid .
3. TIPS will be paid the maturity or the principal value which ever is higher.
4. Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, profiting from a temporary difference in prices. This is considered riskless profit for the investor/trader. If all markets were perfectly efficient, there would never be any arbitrage opportunities - but markets seldom remain perfect. It is important to note that even when markets have a discrepancy in pricing between two equal goods, there is not always an arbitrage opportunity. Transaction costs can turn a possible arbitrage situation into one that has no benefit to the potential arbitrageur. Options can fit a range of investing goals whether it's maximizing your exposure or helping to minimize your risk.