Harvard Management Comapny

1. Describe how TIPS are structured, in particular, how do coupons and principal vary with inflation/deflation and how are they taxed?

TIP’s structure needs the principal and coupon of the bond to change according to the each monthly inflation level which is based on the CPI. First of all, inflation-adjusted principal would be the product of stated value, or the par amount, multiply the index ratio (which is the CPI reference on the valuation date divided by the CPI level on issuing day). So, the inflation or deflation level compared with the original CPI on the valuation date would make the result of paid principal on the maturity day. Secondly, the coupon of the bond is determined by multiplying the inflation-adjusted principal by semi-annually stated interest rate on the interest payment date, which is increasing in accordance with the inflation of principal. Thirdly, tax is applied to the taxable income in which accretion to the principal and the interest paid.

2. If a TIPS bond was issued in late December 2001 with a principal amount of $1,000, what would be its accrued principal at the end of December 2012?

299.38314

3. What is the rationale for investing Harvard University’s endowment fund in TIPS?

In the consideration of the reference, CPI index of education, the inflation level has been rising sharply(100 in Dec, 1997, 220.818 in Dec, 2012). The Harvard Management Company should hedge against the possible loos due to the inflation level. TIPS can provide higher real return of between 3.2% and 4.25% than investing in T-bill or T-bonds as well as hedge solutions against the long term economic phenomenon such as inflation.