1. Indexation: Preserves the real purchasing power of lenders.   Example: Suppose you want to purchase a 2 year coupon bond which has a coupon rate of 5% and a face value of $5000.

a. If the inflation rate is zero and the interest rate is 4%, then the price of the bond is
 
PV =     $250/ (1.04)  + $250/(1.04)²  + $5,000/(1.04)²

      =      $240.38  +  $231.15  +  $4,622.77

b. Now suppose inflation is 4% each year. Note that we know the inflation rate for a year at the end of the year. Given that bond payments are also made at the end of the year, this payment can then be adjusted by the appropriate inflation rate.

                         1              104.00                  $260.00                              $250.00

                         2              108.16                   $270.40                             $250.00

                         2                                         $5,408.00                          $5,000.00

                   PV  =   $260.00/(1.04) +  $270.40/(1.04)²  +    $5,408.00/(1.04)²

                          =      $249.99   +    $250.01   +    $5,000

                          =   $5,500

c. In case you don't know how to adjust nominal values for the inflation rate, use the following formula:

                                               Real $s(CPI/100) = Nominal $s = $250(1.04) = $260

To check your calculations, divide by the appropriate price index to adjust to real $s.

                                              ($250.01/1.0816)100 = $231.15

                                                ($5,000/1.0816)100 = $4,622.78

                                                                        Total = $5,094.31