Suppose that you buy a TIPS (inflation-indexed) bond with a 2-year maturity and a coupon of 4% paid annually. Assume you buy the bond at its face value of $1,000, and the inflation rate is 8% in each year.

a. What will be your cash flow in year 1? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What will be your cash flow in year 2? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. What will be your real rate of return over the two-year period?

a) Cash flow in year 1

Principal = 1000 * 1.08 = 1,080

Cash flow (Interest) = 1,080 * 0.04 = $43.2‬0

b) Cash flow in year 2

Principal = 1080 * 1.08 = 1,166.4‬0

Cash flow (Interest + principal) = $1,213.06‬

Interest = 1,166.4‬0 * 0.04 = $46.66  

Principal = $1,166.4‬0

c) Real rate of return = {(1 + Nominal rate) / (1 + interest rate)} - 1

                                  = {1.04/1.08} / 1

                                  = -3.7%

Explanation:

Treasury Inflation protected securities (TIPS) are securities that take into cognizance inflation, thereby providing the investor with a real rate of return on investment.

For year 1, the principal invested i.e. face value of the bond increases with inflation as seen as calculated above and further increases in year 2 as the inflation rate affects both years.

Since the inflation rate is higher than the nominal rate of the investment, the result of this is that the real rate of return is in the negative.

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