Table Of Content_________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Inflation-indexed Securities
_______________________________________________________________________ ______________________________________________________________________
Bonds, Swaps and Other Derivatives
Second Edition
Mark Deacon
Andrew Derry
and
Dariush Mirfendereski
Published2004JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,
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LibraryofCongressCataloging-in-PublicationData
Deacon,Mark.
Inflation-indexedsecurities:bonds,swapsandotherderivatives/
MarkDeacon,AndrewDerry,andDariushMirfendereski.—2nded.
p.cm.—(Wileyfinanceseries)
Previouslypublished:London:PrenticeHallEurope,1998.
Includesbibliographicalreferencesandindex.
ISBN0-470-86812-0(cloth:alk.paper)
1.Bonds. 2.Governmentsecurities. 3.Bondmarket. 4.Indexation
(Economics) 5.Inflation(Finance) I.Derry,Andrew.
II.Mirfendereski,Dariush. III.Title. IV.Series.
HG4651.D42004
332.6302044—dc22 2003021827
BritishLibraryCataloguinginPublicationData
AcataloguerecordforthisbookisavailablefromtheBritishLibrary
ISBN0-470-86812-0
Typesetin10/12ptTimesbyOriginator,GtYarmouth,Norfolk
PrintedandboundinGreatBritainbyAntonyRoweLtd,Chippenham,Wiltshire
Thisbookisprintedonacid-freepaperresponsiblymanufacturedfromsustainableforestry
inwhichatleasttwotreesareplantedforeachoneusedforpaperproduction.
_________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Contents
____________________________________________________________________________________________________________________________________________ ____________________________________________________________________________________________________________________________________________
List of Exhibits xii
List of Figures xiii
List of Tables xvii
About the Authors xix
Foreword by Sir Edward George xxi
Preface to the Second Edition xxiii
Acknowledgements xxv
Disclaimer xxvii
List of Abbreviations xxix
1 What Are Inflation-indexed Securities and Derivatives? 1
1.1 A historical perspective 1
1.2 How indexed bonds work 4
1.3 The role of derivatives 7
2 Security Design 9
2.1 Choice of price index 9
2.1.1 Index matching 9
2.1.2 Index reliability and integrity 11
2.1.3 Other practical considerations 16
2.2 Cash flow structure 17
2.2.1 Capital Indexed Bond (CIB) 18
2.2.2 Interest Indexed Bond (IIB) 18
2.2.3 Current Pay Bond (CPB) 19
2.2.4 Indexed Annuity Bond (IAB) 21
2.2.5 Indexed Zero-Coupon Bond (IZCB) 22
2.2.6 Other types of indexed bonds 23
2.2.7 Cash flows of the different structures 23
2.2.8 Factors that influence the choice of security design 24
vi Contents
2.3 Application of the index to the cash flows 26
2.3.1 The problem of the indexation lag 26
2.3.2 Why indexation lags are necessary 27
2.3.3 How to minimise the indexation lag 28
2.3.4 Full or partial indexation? 29
2.4 The impact of tax regulations 31
2.4.1 Uncertainty of post-tax real yields 31
2.4.2 The effect of income accrual rules 33
2.5 Options on indexed bonds 34
2.5.1 Callable bonds 34
2.5.2 Puttable bonds 34
2.5.3 Convertible bonds 35
2.6 Method of issue 35
2.6.1 Pricing 36
2.6.2 Cost-effectiveness and market development 37
2.6.3 Consistency with other instruments 37
2.6.4 What happens in practice? 38
2.7 Summary 38
Appendices 39
A2.1 Calculating the base annuity payment for Indexed Annuity
Bonds (IABs) 39
A2.2 Barro’s proposal for revising the inflation adjustment of
payments on index-linked gilts 40
3 Why Invest in Indexed Debt? 43
3.1 Reducing inflation risk 43
3.2 Relative stability of returns 44
3.3 Performance relative to conventional bonds and equities 46
3.4 Total return opportunities 49
3.5 Duration and other cash flow considerations 51
3.6 Taxation 52
3.7 Liquidity 53
3.8 Other potential deterrents to investing in indexed bonds 55
3.9 Alternatives to indexed bonds 55
3.9.1 Treasury bills 55
3.9.2 Equities 56
3.9.3 Property 58
3.10 Summary 58
4 Why Issue Indexed Bonds? 59
4.1 Why governments issue indexed bonds 59
4.1.1 Reducing borrowing costs: the role of inflation
expectations 59
4.1.2 Reducing borrowing costs: saving the inflation risk
premium 61
4.1.3 Risk management 64
Contents vii
4.1.4 Inflation-indexed bonds and monetary policy 65
4.1.5 Maintaining long-term capital markets in difficult
economic conditions 66
4.2 Why private corporations issue indexed bonds 66
4.3 The relative scarcity of index-linked bonds 67
4.4 Summary 71
5 Inflation and Real Interest Rate Analysis 73
5.1 Measures of real interest rates 74
5.1.1 Real gross redemption yields 75
5.1.2 Hedge ratios: the duration and ‘‘beta’’ of
inflation-indexed bonds 77
5.1.3 The term structure of real interest rates 79
5.2 Measures of inflation expectations 80
5.2.1 Break-even inflation rates 81
5.2.2 The ‘‘inflation term structure’’ 82
5.2.3 The inflation risk premium and bond convexity 83
5.3 Analysis of real interest rates and inflation expectations 85
5.3.1 Real interest rates 85
5.3.2 Measures of inflation expectations 89
5.4 Summary 92
6 Major International Indexed Bond Markets 93
6.1 Australia 94
6.1.1 A brief history of indexation in Australia 94
6.1.2 The structure of the Commonwealth Treasury Indexed
Bond (TIB) market 99
6.2 Canada 100
6.3 France 106
6.3.1 The history of indexation in France 106
6.3.2 The introduction of inflation-indexed OATs
(Obligations assimilables du Tre´sor) 107
c
6.3.3 Indexation to pan-European inflation – OAT¼i bonds 113
6.4 Sweden 119
6.4.1 The formation of the Swedish government index-linked
bond market 119
6.4.2 The development of the market toward international
standards 120
6.4.3 Recent developments 124
6.5 United Kingdom 128
6.5.1 A brief history of the index-linked gilt market 128
6.5.2 The structure of the index-linked gilt market 136
6.5.3 The market for non-government index-linked bonds in
the UK 138
6.6 United States of America 141
6.6.1 A brief history of indexation in the USA 141
viii Contents
6.6.2 The launch of the Treasury Inflation-Indexed
Securities (TIIS) market 142
6.6.3 The expansion of the TIIS programme in the fiscal
surplus years 148
6.6.4 Recent developments in the market for inflation-indexed
securities in the USA 151
Appendices 160
A6.1 Cash flow calculations for Australian Capital Indexed Bonds
(CIBs) 160
A6.1.1 Calculation of interest payments 160
A6.1.2 Calculation of the settlement price 161
A6.2 Cash flow calculations for Canadian Real Return Bonds (RRBs) 162
A6.2.1 Indexing process 162
A6.2.2 Calculation of interest payments 163
A6.2.3 Calculation of the redemption payment 163
A6.2.4 Calculation of the settlement price 163
c
A6.3 Cash flow calculations for French OATi and OAT¼i bonds 165
A6.3.1 Indexing process 165
A6.3.2 Calculation of interest payments 167
A6.3.3 Calculation of the redemption payment 167
A6.3.4 Calculation of the settlement price 167
A6.4 Cash flow calculations for Swedish index-linked Treasury bonds 168
A6.4.1 Indexing process 168
A6.4.2 Calculation of interest payments (for coupon-bearing
bonds) 169
A6.4.3 Calculation of the redemption payment 169
A6.4.4 Calculation of the settlement price 169
A6.5 Cash flow calculations for UK Index-linked Gilts (IGs) 171
A6.5.1 Indexing process 171
A6.5.2 Calculation of interest payments 171
A6.5.3 Calculation of the redemption payment 172
A6.5.4 Calculation of accrued interest 173
A6.5.5 Calculation of real yields 174
A6.6 Cash flow calculations for US Treasury Inflation-Indexed
Securities (TIIS) 176
A6.6.1 Indexing process 176
A6.6.2 Calculation of interest payments 177
A6.6.3 Calculation of the redemption payment 177
A6.6.4 Calculation of the settlement price 177
7 Other Indexed Bond Markets 179
7.1 Argentina 180
7.2 Austria 182
7.3 Bolivia 182
Contents ix
7.4 Brazil 182
7.4.1 1964–1986 Readjustable National Treasury Obligations
(ORTNs) 182
7.4.2 1986–today National Treasury Obligations (OTNs),
Treasury Bonds (BTNs) and National Treasury Notes
(NTNs) 184
7.5 Chile 186
7.6 Colombia 188
7.7 Czech Republic 189
7.8 Denmark 191
7.9 Finland 193
7.10 Germany 194
7.11 Greece 194
7.12 Hungary 195
7.13 Iceland 198
7.14 India 201
7.15 Ireland 201
7.16 Israel 202
7.17 Italy 207
7.18 Japan 209
7.19 Kazakhstan 210
7.20 Mexico 210
7.21 Netherlands 212
7.22 New Zealand 212
7.23 Norway 215
7.24 Peru 216
7.25 Poland 216
7.26 Portugal 219
7.27 South Africa 219
7.28 Spain 224
7.29 Switzerland 225
7.30 Turkey 225
Appendices
A7.1 Calculation of the settlement price for Colombian TES-UVR
bonds 227
A7.1.1 Calculation of the settlement price 227
A7.1.2 Price calculation example 227
A7.2 Calculation of the settlement price for Icelandic Treasury Bonds 228
A7.2.1 Indexing process 228
A7.2.2 Calculation of the settlement price 229
A7.2.3 Price calculation example 229
A7.3 Calculation of real yields for Israeli inflation-indexed bonds 230
A7.3.1 Sagi and Galil bonds 230
A7.3.2 Kfir bonds 230
x Contents
A7.4 Cash flow calculations for New Zealand Treasury
inflation-indexed bonds 231
A7.4.1 Calculation of interest payments 231
A7.4.2 Calculation of the settlement price 232
A7.5 Exchange rates 233
8 Inflation-linked Derivatives: Market Description 235
8.1 Overview 235
8.1.1 Introduction 235
8.1.2 Why Inflation-linked (IL) derivatives? 236
8.1.3 The Inflation-linked (IL) derivatives markets in 2003 237
8.2 A brief history of Inflation-linked derivatives markets 239
8.2.1 Early history 239
8.2.2 The UK market 240
8.2.3 The French and Euro-zone markets 242
8.2.4 The Swedish market 244
8.2.5 Non-European markets 244
8.3 Inflation payers (issuers) 246
8.3.1 Standard derivative solutions for Inflation-linked (IL)
issuers 247
8.3.2 Private Finance Initiative (PFI) projects in the UK 250
8.3.3 UK housing associations 253
8.3.4 Swap structures to mitigate credit exposure 254
8.4 Inflation receivers (investors) 255
8.4.1 The use of inflation swaps to hedge pension liabilities 255
8.4.2 Inflation-guaranteed and Inflation-linked (IL) retail
products 255
8.5 Inflation options 258
8.5.1 Options embedded in bonds 258
8.5.2 Standalone inflation options in the Over The Counter
(OTC) market 258
8.6 Future trends 259
8.6.1 Market standardisation 259
8.6.2 Pension reforms in Europe 259
8.6.3 The implications of changes to accounting standards 260
8.6.4 Further development of the inflation derivatives markets 260
Appendix
A8.1 Example swap and option structures 262
A8.1.1 Capital Indexed Bond (CIB)-style swaps 262
A8.1.2 Real annuity swaps 264
A8.1.3 Interest Indexed Bond (IIB)-style swaps 265
A8.1.4 Standard inter-dealer broker market structures 265
9 Inflation-linked Derivatives: Pricing, Hedging and Other Technical Aspects 269
9.1 Outline 269
9.2 Pricing approaches 269
9.2.1 What is meant by ‘‘pricing’’? 269
Contents xi
9.2.2 Four levels of pricing 271
9.2.3 Level I 271
9.2.4 Level II 271
9.2.5 Level III 271
9.2.6 Level IV 272
9.3 Deriving a forward Consumer Price Index (CPI) curve for
Level II and III markets 272
9.3.1 Piecewise linear continuous function in CPI space 273
9.3.2 Piecewise linear continuous function in inflation space 274
9.4 ‘‘Level I’’ markets in Europe: intraregional Euro-zone inflation
spreads 275
9.5 Alternative approaches to the construction of inflation curves 277
9.6 Asset swaps – connecting swap and bond prices 279
9.7 Hedging a swapped new issue 281
9.7.1 A simple ‘‘interim’’ hedge 282
9.7.2 A more precise hedge 283
9.7.3 A portfolio hedge for net outright inflation risk 284
9.8 The evolution of the Euro-zone HICP swap market 285
9.8.1 Seven lessons from seven months of Euro-zone inflation
swap data 286
9.9 Historical estimation of price index volatilities 288
9.10 Pricing inflation options 292
9.10.1 Zero percent zero-coupon floors 293
9.10.2 Year-on-year inflation floors 293
9.11 Summary 295
10 Conclusion 297
References 301
Bibliography 315
Useful websites 317
Index 319
_________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Exhibits
________________________________________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________________________________
c
A8.1 OAT¼i-style versus EURIBOR flat rate or fixed rate 262
A8.2 Real coupon (only) versus EURIBOR flat rate or fixed rate 263
A8.3 Zero-coupon only versus upfront or EURIBOR flat rate – spread 263
A8.4 Real annuity versus compounded fixed rate 264
A8.5 Zero-coupon plus fixed rate versus EURIBOR flat rate 264
A8.6 Year-on-year inflation plus spread versus EURIBOR flat rate 265
A8.7 Standard broker market swaps: zero-coupon swap 266
A8.8 Standard broker market swaps: year-on-year swap 266
A8.9 Standard broker market options: 0% floor on zero-coupon swap 267
A8.10 Standard broker market swaps: 0% floor on a year-on-year swap 267
