Untitled

Assumptions

Throughout the following you may assume the consensus expected average inflation rate for the next twelve months is 2.5%.  One-year treasury notes now sell to yield 5%.  Given their degree of risk aversion and current inflation conditions, Mr. and Ms. Typical Investor would be willing to give up 0.5% in expected return (the inflation risk premium) if they could be free of uncertainty about how much inflation will actually cost them in lost purchasing power of the repayment of a one-year investment.

 

Written Analysis

 

        You are a financial analyst for the U.S. Treasury which has just conceived the idea of issuing TIPS.  [You will recall that, in addition to the pre-stated coupon and principal payments, TIPS adjust all payments to reflect inflation actually realized since the date of issue.  In effect, realized inflation is added ex post to the so called “real yield” calculated from the initial market price, coupon and face value.  See Van Horne p. 72.]  Because inflation indexed securities have previously been completely unknown in the economy, you have been asked to write a memo projecting the likely results.  In particular your memo should estimate

 

1.      The “real yield” at which a one-year TIPS is likely to sell.

2.      The expected borrowing costs to the treasury of issuing this security (including both explicit coupon and principal payments and ex post inflation payments).

3.      The expected savings in borrowing costs, if any, to be realized by issuing TIPS.  

In each case be sure to explain how you calculated your results from the above information.  

4.      If you believe a borrowing cost saving will result, explain why it occurs.  Is the treasury getting something for nothing?