Question

1. Assume that at the end of the second six months the CPI is 3%.
   1. Compute inflation adjustment to principal after end of second 6-month period

2. Compute inflation adjusted principal after end of second 6-month period

3. Compute the coupon payment to the investor at the end of second 6 months

Answer 1

Solution

Question has given that at the end of the second six months the CPI is 3%

What is CPI, it stands of Consumer Price Index or simply we can say inflation, it is saying that end of second six month the inflation rate is 3.00%.

What inflation does:

In simple words, inflation decrease the purchasing power of the money or in other words increase the price of one commodity, Lets understand it with the help of one example with inflation rate of 3%

Now one commodity cost is $100.00 and after second six month it will cost around $103, it says that what commodity is available today for $100 will no longer available for $100 after second six month due to inflation effect,

Let comes to the question again, it ask us to compute 3 things

i. inflation adjustment to principal

ii. inflation adjusted principal

iii. coupon payment to the investor

i)& ii)

Let calculate the inflation adjusted principal and Inflation adjustment to principal at the end of second six month

If we have a principal of $100 and CPI (inflation) is 3%, than our principal will be adjusted with the given CPI which is as follows:

Adjusted Principal = P*(1+R),

Where,

P is the original Prinicpal

R is the rate of inflation

= 100*(1+0.03)

= 100*1.03

= 103

So the principal is adjusted by $3 and adjusted principal is $103

iii) Coupon payment to investor

The coupon payment to the investor is also adjusted with the inflation and new coupon will be calculate as follows

Inflation Adjusted Coupon rate : (1+CR)*(1+IR)

Here

CR is the coupon rate

IR is the Inflation rate

The coupon rate will be increase with the increase in inflation otherwise bond will be no more attractive for the investor because real return will be lessor than the present due to the inflation effect and investor will start selling bond due to its non-attractiveness, so all company has to increase the coupon with the increase in inflation to keep the real return equivalent in all years