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
The correct answer is d.
TIPS are a special type of Treasury note or bond that
offers protection from inflation. When you buy an
inflationindexed 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 semiannual payment of $15.30.
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