ECONOMICS 0281
                                                            HANDOUT #1: INDEXATION

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.

                          =   $5,094.30                                                               Nominal Value of                      Real Value of
                      Year             CPI              Coupon Payment                 Coupon Payment

                         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

                                               Real $s   =   (Nominal $s/CPI)100

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

                                                  ($249.99/1.04)100 = $240.38

                                              ($250.01/1.0816)100 = $231.15

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

                                                                        Total = $5,094.31