PLEASE HELP ME WITH THIS BOND QUESTION

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dnorr

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Feb 9, 2011
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Can you show me how you derived at your answer? Thank you.

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the principal value of the bond at the end of 5 years?

A. $1,000
B. $1,200
C. $1,219
D. $1,440
 
How does a TIPS bond work? Are the coupons semi-annual? Was it redeemed for the principal amount?
 
These notes are issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in the Consumer Price Index (CPI), the standard measurement of inflation. The interest payment the investor receives every six months is equal to the fixed interest amount times the newly adjusted principal.
 
Great. Start with the purchase price and roll it forward one year. Let's see what you get.
 
According to the book, if the inflation rate is 4% for 5 years, the principal value of the bond increases semiannually by that inflation rate. Allowing for compounding, you would multiply $1,000 by 102% ten times which would put the answer at C. $1,219. But it doesn't explain how they came up with the 102% figure. Any idea?
 
If I need to calculate the final semiannual interest check, the book says that I should take $1,218 x 1.75% to get $21.33.

My question is, what does the 1.75% represent? How does this reflect a semiannual calculation rather than 2%?
 
Annual Bond Rate: 3.50%
Semi-Annual Bond Rate: 1.75%
 
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