Question

An inflation-indexed 3-year, annual 4% coupon bond issued by Thailand at par (Present Value =Par Value = 100 Thai Bhat initially). Inflation in Thailand increases by 5 % in year 1, by 4 % in year 2, and zero % in year 3. What is the coupon amount in Thai Bhat in year 2?

a. Bhat 4.20

b. Bhat 4.00

c. Bhat 5.00

d. Bhat 4.37

Answer 1

In inflation indexed bonds the principal is indexed to inflation. The purpose of these bonds is to hedge the risk related to inflation in a bond. The coupon amount is paid on principal value adjusted for inflation.

Par Value of bond initially = 100 Thai Bhat
Inflation in Year 1 = 5%
Inflation in Year 2 = 4%
Inflation in Year 3 = 0%

Principal value adjusted for inflation in year 2 = Initial Par Value * (1+Inflation Rate in Year 1) * (1+Inflation Rate in Year 2)
                                                        = 100 * (1+0.05) * (1+0.04)
                                                        = 100 * 1.05 * 1.04
                                                        = 109.2 Thai Bhat

Coupon Amount in year 2 = Principal value adjusted for inflation in year 2 * Coupon Rate
                                          = 109.2 * 4%
                                          = 4.37 Thai Bhat

Option d. is correct.