Question

		a) Assume an inflation protection bond (TIPS) with 30 years remaining to expiration carries a coupon rate of 4.25% and is sold for $900. The par value of the bond is $1,000. Complete the table below and show all calculations in each cell.
YR	Inflation		Interest Received	Accrued Principal value	Interest earned due to inflation	Total return	ROR (Nominal)	Real ROR
1	3.0%
2	2%
3	1 %
4	Minus 1% It is a negative rate of inflation

b) If the coupon rate of an inflation protection bond (TIPS) is 2.75% and it is sold at par or $1,000.

What is the annual real return on this bond for a buy and hold investor. Assume inflation is +2%.

c) If the coupon rate of an inflation protection bond (TIPS) is 2.75% and it is sold at par or $1,000. What is the annual real return on this bond for a buy and hold investor. Assume inflation is -2% (that is, minus 2%).

d) List 3 important features of inflation protection bonds. Explain each feature in 3 lines.

Answer 1

(a) Par Value = $ 1000. Market Value = $ 900, Coupon Rate = 4.25 %, Time to Maturity = 30 years

Annual Coupon = 0.0425 x 1000 = $ 42.5

Year	Inflation	Interest Earned	Accrued Principal Value	Interest Earned due to Inflation	Total Return	Nominal ROR	Real ROR
1	3 %	(1000 x 0.0425) = $ 42.5	(0.03 x 1000) = $ 30	(0.0425 x 30) = $ 1.275	$43.775	(43.775+30) / 1000 = 7.3775 %	(1.073775/1.03) = 1.0425 or 4.25 %
2	2 %	(1000 x 0.0425) = $ 42.5	(0.02 x 1030) = $ 20.6	(0.0425 x 50.6) = $ 2.1505	$ 44.6505	(44.6505 + 20.6) / 1030 = 6.335 %	1.06335 / 1.02 = 1.0425 or 4.25 %
3	1 %	(1000 x 0.0425) = $ 42.5	(1050.6 x 0.01) = $ 10.506	(0.0425 x 61.06) = $ 2.597005	$ 45.097005	(45.097005 + 10.506) / 1050.6 = 5.2925%	(1.052925/1.01) = 1.0425 or 4.25 %
4	- 1 %	(1000 x 0.0425) = $ 42.5	(1061.106 x -0.01) = $ - 10.61106	(0.0425 x 50.49494) = $ 2.14603495	$44.64603495	(44.64603495-10.61106) / 1061.106 = 3.2075 %	(1.032075/0.99) = 1.0425 or 4.25 %

NOTE: Please raise a separate query for solutions ot the remaining questions.