Q:

It is now 6 month after you just purchased a \$1,000 face value TIPS (Treasury Inflation Protected Security). If the current inflation rate is 4% per year, and the security pays an annual coupon rate of 3%. What is the coupon payment that you can expect to receive today?
a) \$30.60
b) \$15
c) \$6.50
d) \$15.30
e) \$30

A:

TIPS are a special type of Treasury note or bond that offers protection from inflation. When you buy an inflation-indexed security, you receive interest payments every six months and a payment of principal when the security matures. The difference with TIPS are that the coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI).
To calculate the coupon payment you must first adjust the principal for inflation. In this example:
\$1,000 x [1 + (1/2)(0.04)] = \$1,020 is the adjusted inflation principal.
Now we can easily calculate the coupon payment as follows:
\$1,020 x [(1/2)(0.03)] = \$15.30
After purchasing the TIPS 6 months ago we can expect to receive a semi-annual payment of \$15.30.

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