Question

suppose that you buy a tips (inflation-indexed) bond with a 2-year maturity and a (real) coupon of 5.7% paid annually. if you buy the bond at its face value of $1,000, and the inflation rate is 10.55% in each year. what will be your cash flow in year 1?

Answer 1

To calculate the cash flow in year 1 of a 2-year tips bond with a 5.7% real coupon rate and 10.55% inflation rate, you need to determine the inflation-adjusted coupon payment and face value of the bond. The cash flow in year 1 is $1,170.0045.

Step-by-step explanation:

To calculate the cash flow in year 1, we need to determine the inflation-adjusted value of the coupon payment and the face value of the bond.

First, we calculate the inflation-adjusted coupon payment for year 1. The coupon payment of 5.7% is stated in real terms, so we multiply it by the inflation rate of 10.55%:

Inflation-adjusted coupon payment = $1,000 x 5.7% x (1 + 10.55%) = $1,000 x 0.057 x 1.1055 = $64.5045

Next, we calculate the inflation-adjusted face value of the bond:

Inflation-adjusted face value = $1,000 x (1 + 10.55%) = $1,000 x 1.1055 = $1,105.5

Therefore, the cash flow in year 1 is the sum of the inflation-adjusted coupon payment and the inflation-adjusted face value: $64.5045 + $1,105.5 = $1,170.0045.