2. Judy Johnson is choosing between investing in two Treasury securities that ma

Question

2. Judy Johnson is choosing between investing in two Treasury securities that mature in five years and have par values of $1,000. One is a Treasury note paying an annual coupon of 5.06 percent. The other is a TIPS which pays 3 percent interest annually.

a.If inflation remains constant at 2 percent annually over the next five years, what will be Judys annual interest income from the TIPS bond? From the Treasury note?

b. .How much interest will Judy receive over the five years from the Treasury note? From the TIPS?

c. When each bond matures, what par value will Judy receive from the Treasury note? The TIPS?

d. After five years, what is Judy's total income (interest par) from each bond? Should she use this total as a way of deciding which bond to purchase?

Explanation / Answer

If inflation over the next five years is 2%, the principle value rises to $1000 plus 2% or $1,020. The effective interest, what we are effectively earning on the tips with the inflation, is 5.06% - 2% = 3.06%. Judy's annual interest income from the TIPS bond = 1000 x 0.02 x 5 = $100
Judy's annual interest income from the TIPS bond
First year: value: 1020 interest 30.6
Second year: value: 1040.4 interest: 31.21
Third year: value: 1061.21 interest: 31.84
Fourth year value: 1082.43 interest: 32.47
Fifth year value: 1104.08 interest: 33.12

Judy's annual interest income from the Treasury note
First year: value: 1020 interest 51.61
Second year: value: 1040.4 interest: 52.64
Third year: value: 1061.21 interest: 53.70
Fourth year value: 1082.43 interest: 54.77
Fifth year value: 1104.08 interest: 55.87

b. The Treasury note? From the TIPS?

Interest from Treasury note: 205.76
Interest The TIPS: 333.95

c.From the Treasury note? The TIPS? If the bond matures 3 %, then Judy should receive a value of $30.00

$.03 % x $1,000 = $30.00

d. Treasury = 1253

Tips = 1150

Should she use this total as a way of deciding which bond to purchase?

The total amount to be added after finding out the present value of cash flow of each year by market interest rate, but if the market interest rate is the same for each kind of bonds, the present value of cash flow for each year will be equal to par value of $1000

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