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How TIPS (or TIIS) Works

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cnbunny's version from 2018-02-23 06:45

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Question Answer
What does TIPS stand for?Treasury-Inflation Protected Securities
What are TIPS?financial asset that pays a fixed rate of interest every 6 months on the principal which is adjusted for inflation as measured by the CPI-U, published monthly by the BLS (Bureau of Labor Statistics)
The --- for TIPS remains fixed - only the --- is adjusted.interest rate
principal
The principal can decline during deflation, but at maturity, the greater of the face value or the adjusted principal is paid.
TIPS maturity terms are ---, ---, and --- years.5, 10, 20
TIPS interest payment = --- x ---annual interest (fixed)
adjusted principal
Federal taxes must be paid on both the interest and on increases in adjusted principal in the year earned.
An indexed security issued at time t with coupon rate of c, a maturity of N years, and a par (face) value of $100 has coupon payments after n years of ---, where Pt+n is the reference CPI at time t+n, and a principal payment after N years of ---.
How can investors benefit from inflation-indexed debts aka TIPS?New type of asset that reduces the risks associated with inflation.
Locks in real rate of return.
Protects themselves against the possibility that an unexpected rise in inflation would erode the real return on nominal debt security.
How can the Treasury benefit from issuing inflation-indexed debt aka TIPS?Reduce its financing costs. < /br> Eliminates risk for investors and therefore avoid having to pay this "inflation risk premium".
What other ancillary benefits does issuing indexed debt have?Provide policymakers and market participants with useful reading of real interest rates.
Comparing yields on TIPS with those on national securities provide measure of the amount of compensation that investors demand to offset future inflation and associated risks.
The formula for price of the inflation-indexed security at time t determined by the sum of future nominal
This price differs from the computation of the value of nominal security in that the discount rate used is the --- and not the --- rate

real
nominal
Why do TIPS have a low relative valuation?investor difficulty adjusting to a new asset class
lower liquidity of TIPS (TIPS are primarily held by "end users", or investors that tend to buy and hold the instruments
supply trends (the fairly rapid growth of TIPS supply when investor participation was subdued)
Because of the low valuation of TIPS relative to nominal securities, inflation-indexed debt has not yet lived up to its purpose of --- financial costs for the Treasury.reducing
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