CT1 Chapter 12, Example 12.18

[Polina Hadjipanayiotou]

Can someone help me on this question?



I didnt understand why the coupons start on February 2008 and not 2006 and if then that's the case for this specific bond, why then in the solution the first 2008 coupon is not discounted to 2 years and its only discounted for half-year?

How do we understand that the coupon payment for every half year stays the same at 2.10?

And also why this 2008 coupon payment is assumed to include the past inflation?

Thanks

 

[Net Premium]

The non-taxpaying investor doesn't buy the stock until 29 Feb 2008 and so we don't need to worry about the coupons in the past.
The coupons don't stay the same. The last one was 2.10 and so the next one is 2.10*1.0525^.5 as used in the equation.
We are told the Feb 2008 coupon was 2.10. The coupons increase with inflation so it must have increased with past inflation from its base amount.

 

[Polina Hadjipanayiotou]

The non-taxpaying investor doesn't buy the stock until 29 Feb 2008 and so we don't need to worry about the coupons in the past.
The coupons don't stay the same. The last one was 2.10 and so the next one is 2.10*1.0525^.5 as used in the equation.
We are told the Feb 2008 coupon was 2.10. The coupons increase with inflation so it must have increased with past inflation from its base amount.

Great, thank you very much now everything makes sense again! I have though another question, regarding the redemption payment. Why do we need to include also the 2 years of past inflation and not just the inflation after 2008, since he purchased the stock Feb 2008?

 

[Mark Mitchell]

The coupon and redemption payments on an index-linked bond are calculated with reference to the index value relating to the date of issue of the bond (not the date that a particular investor happens to purchase the bond). In the notes the index value relating to the date of issue is called the "base value" and is denoted Q(0).

So, in the question above, since the redemption payment is 18 years after the date of issue, it is calculated allowing for 18 years of inflation (2 past and 16 future).

Note that in some questions you'll be told there is a time lag for indexation purposes, which will adjust the index values used for indexation (but that's not a feature of this question).