An investor purchases a TIPS bond with a 3% coupon. During the first year, if the inflation rate is 8%, the principal value of the security at the end of that year will be closest to:_________

TIPS stand for Treasury Inflation-Protected Securities, which means that the principal value of the security will be adjusted to inflation. The coupon rate is not adjusted, but since the principal is, if inflation rises, you will receive a higher coupon rate and the maturity value of the security will also increase.

chilljain33 chilljain33 · Answer 2 · 2021-12-30T14:15:34+01:00

Here we are assuming that the value of the principal amount of bond investment is $4000, so the principal value of security at the end of the year will be $4320.

The calculation is done by taking the inflation rate into consideration which is 8% as compared to coupon rate 3%. The rate of Interest is taken as 8% as the inflation rate is greater than the coupon rate.

The TIPS bonds are also referred to as the Treasury-Inflation Protected Security bonds and as the name suggests if the inflation rate beats the coupon rate of such bonds it is applied to the appreciation.

The coupon rate over these bonds is generally lower than the average inflation rate every year as it makes the investors secured that their money is at least at par with the rate of inflation.

The calculation of principal value of such bonds at the maturity of one year can be calculated using the following formula,

[tex]\rm Principal\ Value= Amount\ Invested\ x\ (1+\ Inflation\ Rate)[/tex]

Putting the values in the formula we get,

[tex]\rm Principal\ value= 4000\ x\ (1+0.08)[/tex]

[tex]\rm Principal\ value= 4000\ x\ 1.08[/tex]

Therefore the principal value of the bond is obtained as $4320.

Hence, the correct value of the TIPS bond in which an investor invests his money will grow to a value of $4320.

To know more about TIPS bonds, click the link below.

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