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Portfolio Basics Series 65

Key Concepts:

Terms in this set (48)

The best answer is D.
A TIPS is a Treasury Inflation Protection Security - which grows principal at the rate of inflation each year and the interest paid each year is based on the inflated principal amount.

In year 1, the investor will get $1,000 x 3% = $30 of interest. At the end of year 1, the principal is adjusted by the 3% inflation rate. $1,000 x 1.03 = $1,030 adjusted principal amount.

In year 2, the investor will get $1,030 x 3% = $30.90 of interest. At the end of year 2, the principal is adjusted by the 4% inflation rate. $1,030 x 1.04 = $1,071.20 adjusted principal amount.

In year 3, the investor will get $1,071.20 x 3% = $32.14 of interest. At the end of year 3, the principal is adjusted by the 4% inflation rate. $1,071.20 x 1.04 = $1,114.05 adjusted principal amount.

In year 4, the investor will get $1,114.05 x 3% = $33.42 of interest. At the end of year 4, the principal is adjusted by the 4% inflation rate. $1,114.05 x 1.04 = $1,158.61 adjusted principal amount.

In year 5, the investor will get $1,158.61 x 3% = $34.76 of interest. At the end of year 5, the principal is adjusted by the 5% inflation rate. $1,158.61 x 1.05 = $1,216.54 adjusted principal amount. This is the redemption price after year 5.

Thus, the investor's Total Return is 5 years of interest plus 5 years of appreciation. The 5 years of interest totals $161.22. The 5 years of appreciation totals $216.54.

The Total Return over 5 years is $161.22 + $216.54 = $377.76 / $1,000 invested = 38% (rounded). Note that this question asks for 5 year Total Return; not for annualized return. Also note that from the choices given, if you understand that the 5 years returns are added up to get the "Total", then doing all this math was not needed! Eyeballing the choices gives the answer!