An important feature of TIPS is that the principal amount cannot go below 100. In other words, if the index ratio goes under one this parameter is automatically set to one. This is important in cases when there is deflation (negative inflation), because in this scenario the value of the principal decreases. Yet given the previously stated rule, the fall in the reference CPI cannot go below its original value at inception. Usually there is little or no deflation so index ratios on TIPS tend to accumulate high values: Even in the event of deflation the value is too high to send it below one. Yet this isn't the case for recently issued on-the-run TIPS. Suppose today is January 16, 2002 and you have the TIPS data in Panel A of Table 7.9.
(a) Consider now the TIPS in Panel B of Table 7.9. You notice that the index ratio is very close to one: This means that the security has not accumulated much inflation since it was issued (October 15, 2001). This makes it very easy for it to go below one if there is a little deflation in the next period. What happens to this bond if there is deflation? Is the cash from the coupon higher, lower, or the same as if there wasn't any inflation?
(b) Is this bond more or less valuable than any of the others in Panel A?
(c) Consider the real term structure of interest rates computed above. Given those parameters, what is the price of this security?
(d) What is the squared pricing error of this security? Is it very different from the ones for the other securities in Panel A?
(e) What is the difference in terms of the clean prices?
(f) Does this analysis reflect you answer in Part (c) above?