Treasury Inflation Protected Securities problem
Since 1997, the US 100 Treasury has provided inflation insurance to interested parties through its TIPS program. TreasuryDirect explains:
“Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases. The relationship between TIPS and the Consumer Price Index affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases. At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation…. TIPS are issued in terms of 5 (auction dates: April, *August, *December), 10 (January, *March, *May, July, *September, *November), and 30 (February, *June, *October) years” (* denotes a reopening, in which the US Treasury sell an additional amount of a previously issued security; www.treasurydirect.gov/indiv/research/indepth/tips… tips.htm).
You might want to refer to recent TIPS auction results on treasurydirect.gov and the attached analyst report by Fidelity (September 2020), U.S. Treasury Inflation-Protected Securities.
(a) What is the rationale to invest in a TIPS? How has it changed since 2022?
(b) How much have investors apparently been willing to pay for this privilege recently? You might want to consult recent US Treasury auction results carefully documenting your information source and data.
(c) Given the rapidly changing economic outlook, TIPS all of a sudden look attractive for several reasons. In addition to the investment rationale identified earlier, can you identify another benefit from holding TIPS for investors? How would you exploit this interesting attribute of TIPS?
(d) Decompose the price of a TIPS into its constituent parts. How does it relate to standard US Treasury security of the same maturity?
(e) Based on your decomposition of a TIPS, what would be clear violation of the no-arbitrage condition? How would you take advantage of such a situation?