Question

Suppose that you buy a TIPS (inflation-indexed) bond with a 2-year maturity and a coupon of 4.7% paid annually. Assume you buy the bond at its face value of $1,000, and the inflation rate is 9.05% in each year.

a. What will be your cash flow in year 1?

b. What will be your cash flow in year 2?

B.

Answer 1

For a TIPS bond, the face value is adjusted each year at the inflation rate. The coupon payment is calculated on this adjusted face value.

a]

cash flow in year 1 = face value * (1 + inflation rate) * coupon rate

cash flow in year 1 = $1,000 * (1 + 9.05%) * 4.7% = $51.25

b]

cash flow in year 1 = (face value * (1 + inflation rate)²) +  (face value * (1 + inflation rate)² * coupon rate)

cash flow in year 1 = ($1,000 * (1 + 9.05%)²) + ($1,000 * (1 + 9.05%)² * 4.7%) = $1,245.08