Question

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.

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

Answer 1

The year 1 cash flow from a TIPS bond with an original face value of $1,000 and an 8% inflation rate would be $43.20, calculated by adjusting the principal for inflation and then applying the 4% coupon rate.

Step-by-step explanation:

To calculate the cash flow in year 1 from an inflation-indexed bond such as a TIPS bond with a coupon of 4%, you first adjust the principal to account for inflation. The face value of the bond is $1,000. With an 8% inflation rate, the adjusted principal after one year becomes $1,000 × (1 + 0.08) = $1,080.

The annual coupon payment is then based on this new adjusted principal amount. At a 4% coupon rate, the cash flow for the first year is 4% of the adjusted principal, which would be $1,080 × 0.04 = $43.20.

Therefore, your cash flow in year 1 from this TIPS bond would be $43.20.