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.

- 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)

= $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.

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

- 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