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

CPI is an abbreviation for Consumer Price Index which basically a measure of inflation. Now inflation is an increase in the price of goods or services in an economy. Inflation decreases the purchasing power of money.

Now in this question, it is stated that "at the end of the second six months the CPI (Consumer Price Index) is 3%. To understand this, here is an example -

Suppose the price of a baseball bat in a market is $50 and after six months the same baseball bat will cost $51.50, which means that the baseball bat is available for $50 today but will not cost the same in a period of six months just because of the fact - inflation.

Adjusted Principal = Principal*(1+Rate of Inflation) = P*(1+R)

= 50*(1+3%) = 50*(1+0.03)

= 50*(1.03)

= 51.50

i) Compute inflation adjustment to the principal after the end of the second 6-month period:-

Inflation Adjustment to Principal = Adjusted Principal - Principal = 51.50 - 50 = $1.50. Therefore, the inflation adjustment to principal after end of second 6 month period is $1.50.

ii) Compute inflation adjusted principal after end of second 6-month period:-

Adjusted Principal = $51.50. Therefore, the inflation adjusted principal after end of second 6-month period is $51.50.

iii) Compute the coupon payment to the investor at the end of second 6 months

Inflation adjusted coupon rate = (1+Coupon Rate)*(1+Rate of Inflation)

If the Rate of Inflation increases, the Coupon Rate will also increase just because of the fact that the investment will otherwise become non-profitable for the investor. And the reason behind it is, that the return on investment would be less or lower than the present due to the inflation in an economy. The investor will start selling the investment because of its non-profitable character, so all the companies in the industry have to increase the coupon rate to keep the return equivalent in future.