### CFA Practice Question

Assume the following information about a TIPS:

Original principal: \$500,000
Annual coupon rate: 3.5%
Annual inflation rate: 3.25%

What are the first two coupon payments for this Treasury Inflation Protection Security?
A. \$8,892.19; \$9,036.69.
B. \$8,409.38; \$8,892.19.
C. \$8,892.19; \$8,892.19.
Explanation: Treasury Inflation Protection Securities (TIPS) were first issued on January 29, 1997 by the U.S. Department of the Treasury as a means for investors to experience an inflation-adjusted rate of return on government securities. The coupon rate on TIPS is set at a fixed rate, and these securities pay interest semiannually. The coupon rate is determined via an auction process and is referred to as the "real rate" because it is the rate of interest that an investor will experience above the inflation rate. The index used by the Treasury to compute inflation is the non-seasonally-adjusted U.S. City Average All Items Consumer Price Index for All Urban Customers (CPI-U).

The principal value of a TIPS is adjusted semiannually, and the cash flows of the TIPS profiled in this example is shown below:
1st coupon payment = {[\$500,000 principal * (1 + 0.01625 semiannual inflation rate)] * 0.0175 semiannual coupon rate} = \$8,892.19. The principal amount now is \$508,125.
2nd coupon payment = {[\$508,125 principal * (1 + 0.01625 semiannual inflation rate)] * 0.0175 semiannual coupon payment} = \$9,036.69