Inflation-Indexed Bonds: TIPS [Basic Investing I Studied #8]

OK so now we need to bring in one more variable to actually make sense of interest rates.

That variable is inflation.

And honestly? This is a pretty meaningful expansion.

Why?

Imagine you got a 5% return on your portfolio. Nice. But what if prices also went up by exactly 5%????

That’s… just breaking even, right???

So can we really say any value was added? Not really. The asset price just floated up alongside inflation. Numerically it shows up as a number we call “return,” sure —

but did profit actually happen? Like, for real? Mmmm… it’s hard to say yes?????

OK OK OK.

So first thing: let’s fix the interest rate. (I swear I’ve re-studied this how many times now while doing econ…)

Enter the real interest rate.

The real interest rate $r_t$ for year $t$ and the nominal interest rate $i_t$ for year $t$ are related like this:

$$\therefore \quad r_{t}\quad \cong \quad i_{t}\quad -\quad \pi_{t+1}^{e}$$

This is called the Fisher equation, because — well, Irving Fisher derived it.

The important thing to notice: this is an approximation. And what it’s approximating is equilibrium. Meaning — a gap can show up at any time.

For the exact derivation you have to do… Taylor expansion. Again. And honestly, doing a full Taylor series here would be such a waste of space, right???

I already wrote out the careful derivation over here, so just pop over and check it if you want the full thing.

Real interest rate [Things I studied in Macroeconomics #14]
OK. From here on, let’s look at expectations. In our economy, people’s “expectations” are enormous…

So! It’s worth knowing about TIPS (Treasury Inflation-Protected Securities), which the US rolled out in 1997. It’s a bond that bakes inflation in, and the return you get out of it is — apparently — the truly risk-free rate of return.

But! We’ll go deep on this bond in Chapter 10.

The only reason I’m name-dropping it here is so that when it shows up in Chapter 10 it doesn’t feel like it fell out of the sky. Studying it for real? Save it for Chapter 10. Let’s go let’s go let’s go.

So now — staying inside Chapter 5 —

we head into the last part.

Let’s go, go, go!

Originally written in Korean on my Naver blog (2016-04). Translated to English for gdpark.blog.