2. Consider a newly issued TIPS bond with a three year maturity, par value of $1

Question

2. Consider a newly issued TIPS bond with a three year maturity, par value of $1000, and a coupon rate of 7%. Assume annual coupon payments.

Time

Inflation in year just ended

Par Value

Coupon Payments

Principal Payment

Total Payment

0

$1000.00

1

3%

2

4%

3

5%

Fill in the shaded cells with amounts in the above table.

What is the nominal rate of return on the TIPS bond in the first year?

What is the real rate of return on the TIPS bond in the first year?

Time

Inflation in year just ended

Par Value

Coupon Payments

Principal Payment

Total Payment

0

$1000.00

1

3%

2

4%

3

5%

Explanation / Answer

The table with the cells filled in is given below:

The nominal rate of return on the TIPS bond in the 1st year = 72.1/1000 = 7.1 %

Real rate of return on the TIPS bond in the first year = 72.1/1030 = 7%

Time Inflation in year just ended Par Value Coupon Payments Principal Payment Total Payment 0 $1,000.00 1 3% 1030.00 72.10 0 72.10 2 4% 1071.20 74.98 0 74.98 3 5% 1124.76 78.73 1124.76 1203.49

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