2008 AGI-Information Management Consultants May be used for personal purporses only or by libraries associated to dandelon.com network. Infla tion-indexed Securities Bonds, Swaps and Other Derivatives Second Edition Mark Deacon Andrew Derry and Dariush Mirfendereski John Wiley & Sons, Ltd
List of Exhibits List of Figures List of Tables About the Authors Foreword by Sir Edward George Preface to the Second Edition Acknowledgements Disclaimer List of Abbreviations xii xiii xvii xix xxi xxiii xxv xxvii xxix 1 What Are Inflation-indexed Securities and Derivatives? 1.1 A historical perspective 1.2 How indexed bonds work 1.3 The role of derivatives 2 Security Design 2.1 Choice of price index 2.1.1 Index matching 2.1.2 Index reliability and integrity 2.1.3 Other practical considerations 2.2 Cash flow structure 2.2.1 Capital Indexed Bond (CIB) 2.2.2 Interest Indexed Bond (IIB) 2.2.3 Current Pay Bond (CPB) 2.2.4 Indexed Annuity Bond (IAB) 2.2.5 Indexed Zero-Coupon Bond (IZCB) 2.2.6 Other types of indexed bonds 2.2.7 Cash flows of the different structures 2.2.8 Factors that influence the choice of security design 9 9 9 11 16 17 18 18 19 21 22 23 23 24
vi 2.3 2.4 2.5 2.6 2.7 Application of the index to the cash flows 2.3.1 The problem of the indexation lag 2.3.2 Why indexation lags are necessary 2.3.3 How to minimise the indexation lag 2.3.4 Full or partial indexation? The impact of tax regulations 2.4.1 Uncertainty of post-tax real yields 2.4.2 The effect of income accrual rules Options on indexed bonds 2.5.1 Callable bonds 2.5.2 Puttable bonds 2.5.3 Convertible bonds Method of issue 2.6.1 Pricing 2.6.2 Cost -effectiveness and market development 2.6.3 Consistency with other instruments 2.6.4 What happens in practice? Summary 26 26 27 28 29 31 31 33 34 34 34 35 35 36 37 37 38 38 Appendices A2.1 Calculating the base annuity payment for Indexed Annuity Bonds (IABs) A2.2 Barro s proposal for revising the inflation adjustment of payments on index-linked gilts 3 Why Invest in Indexed Debt? 3.1 Reducing inflation risk 3.2 Relative stability of returns 3.3 3.4 Performance relative to conventional bonds and equities Total return opportunities 3.5 Duration and other cash flow considerations 3.6 Taxation 3.7 Liquidity 3.8 Other potential deterrents to investing in indexed bonds 3.9 Alternatives to indexed bonds 3.9.1 Treasury bills 3.9.2 Equities 3.9.3 Property 3.10 Summary 4 Why Issue Indexed Bonds? 4.1 Why governments issue indexed bonds 4.1.1 Reducing borrowing costs: the role of inflation expect ations 4.1.2 Reducing borrowing costs: saving the inflation risk premium 4.1.3 Risk management 39 39 40 43 43 44 46 49 51 52 53 55 55 55 56 58 58 59 59 59 61 64
4.1.4 4.1.5 Inflation-indexed bonds and monetary policy Maintaining long-term capital markets in difficult economic conditions 4.2 Why private corporations issue indexed bonds 4.3 The relative scarcity of index-linked bonds 4.4 Summary 5 Inflation and Real Interest Rate Analysis 5.1 Measures of real interest rates 5.1.1 Real gross redemption yields 5.1.2 Hedge ratios: the duration and beta of inflation-indexed bonds 5.1.3 The term structure of real interest rates 5.2 Measures of inflation expectations 5.2.1 Break-even inflation rates 5.2.2 The inflation term structure 5.2.3 The inflation risk premium and bond con rex t Y 5.3 Analysis of real interest rates and inflation expectations 5.3.1 Real interest rates 5.3.2 Measures of inflation expectations 5.4 Summary vii 65 66 66 67 71 73 74 75 77 79 80 81 82 83 85 85 89 92 6 Major International Indexed Bond Markets 6.1 Australia 6.1.1 6.1.2 6.2 6.3 6.4 6.5 6.6 Canada France 6.3.1 6.3.2 6.3.3 Sweden 6.4.1 6.4.2 A brief history of indexation in Australia The structure of the Commonwealth Treasury Indexed Bond (TIB) market The history of indexation in France The introduction of inflation-indexed OATS (Obligations assimilables du Tresor) Indexation to pan-european inflation - OAT i bonds The formation of the Swedish government index-linked bond market The development of the market toward international standards 6.4.3 Recent developments United Kingdom 6.5.1 A brief history of the index-linked gilt market 6.5.2 The structure of the index-linked gilt market 6.5.3 The market for non-government index-linked bonds in the UK United States of America 6.6.1 A brief history of indexation in the USA 93 94 94 99 100 106 106 107 113 119 119 120 124 128 128 136 138 141 141
... Vlll 6.6.2 6.6.3 6.6.4 The launch of the Treasury Inflation-Indexed Securities (TIIS) market The expansion of the TIIS programme in the fiscal surplus years Recent developments in the market for inflation-indexed securities in the USA 142 148 151 Appendices A6.1 Cash flow calculations for Australian Capital Indexed Bonds (CIBs) A6.1.1 Calculation of interest payments A6.1.2 Calculation of the settlement price A6.2 Cash flow calculations for Canadian Real Return Bonds (RRBs) A6.2.1 Indexing process A6.2.2 Calculation of interest payments A6.2.3 Calculation of the redemption payment A6.2.4 Calculation of the settlement price A6.3 Cash flow calculations for French OATi and OAT i bonds A6.3.1 Indexing process A6.3.2 Calculation of interest payments A6.3.3 Calculation of the redemption payment A6.3.4 Calculation of the settlement price A6.4 Cash flow calculations for Swedish index-linked Treasury bonds A6.4.1 Indexing process A6.4.2 Calculation of interest payments (for coupon-bearing bonds) A6.4.3 Calculation of the redemption payment A6.4.4 Calculation of the settlement price A6.5 Cash flow calculations for UK Index-linked Gilts (IGs) A6.5.1 Indexing process A6.5.2 Calculation of interest payments A6.5.3 Calculation of the redemption payment A6.5.4 Calculation of accrued interest A6.5.5 Calculation of real yields A6.6 Cash flow calculations for US Treasury Inflation-Indexed Securities (TIIS) A6.6.1 Indexing process A6.6.2 Calculation of interest payments A6.6.3 Calculation of the redemption payment A6.6.4 Calculation of the settlement price 160 160 160 161 162 162 163 163 163 165 165 167 167 167 168 168 169 169 169 171 171 171 172 173 174 176 176 177 177 177 7 Other Indexed Bond Markets 7.1 Argentina 7.2 Austria 7.3 Bolivia 179 180 182 182
ix 7.4 Brazil 182 7.4.1 1964-1 986 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 A7.2 A7.3 bonds A7.1.1 Calculation of the settlement price A7.1.2 Price calculation example Calculation of the settlement price for Icelandic Treasury Bonds A7.2.1 Indexing process A7.2.2 Calculation of the settlement price A7.2.3 Price calculation example Calculation of real yields for Israeli inflation-indexed bonds A7.3.1 Sagi and Galil bonds A7.3.2 Kfir bonds 227 227 227 228 228 229 229 230 230 230
X A7.4 Cash flow calculations for New Zealand Treasury inflation-indexed bonds A7.4.1 Calculation of interest payments A7.4.2 Calculation of the settlement price A7.5 Exchange rates 8 Inflation-linked Derivatives: Market Description 8.1 Overview 8.1.1 Introduction 8.1.2 Why Inflation-linked (IL) derivatives? 8.1.3 The Inflation-linked (IL) derivatives markets in 2003 8.2 A brief history of Inflation-linked derivatives markets 8.2.1 Early history 8.2.2 The UK market 8.2.3 8.2.4 The French and Euro-zone markets The Swedish market 8.2.5 Non-European markets 8.3 Inflation payers (issuers) 8.3.1 Standard derivative solutions for Inflation-linked (IL) issuers 8.3.2 Private Finance Initiative (PFI) projects in the UK 8.3.3 UK housing associations 8.3.4 Swap structures to mitigate credit exposure 8.4 Inflation receivers (investors) 8.4.1 The use of inflation swaps to hedge pension liabilities 8.4.2 Inflation-guaranteed and Inflation-linked (IL) retail products 8.5 Inflation options 8.5.1 Options embedded in bonds 8.5.2 Standalone inflation options in the Over The Counter (OTC) market 8.6 Future trends 8.6.1 Market standardisation 8.6.2 Pension reforms in Europe 8.6.3 8.6.4 The implications of changes to accounting standards Further development of the inflation derivatives markets Appendix A8.1 Example swap and option structures A8.1.1 Capital Indexed Bond (CIB)-style swaps A8.1.2 Real annuity swaps A8.1.3 Interest Indexed Bond (1IB)-style swaps A8.1.4 Standard inter-dealer broker market structures 9 Inflation-linked Derivatives: Pricing, Hedging and Other Technical Aspects 9.1 Outline 9.2 Pricing approaches 9.2.1 What is meant by pricing? 23 1 23 1 232 233 235 23 5 23 5 236 237 239 239 240 242 244 244 246 247 250 253 254 255 255 255 258 258 258 259 259 259 260 260 262 262 264 265 265 269 269 269 269
9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.1 1 9.2.2 Four levels of pricing 9.2.3 Level I 9.2.4 Level I1 9.2.5 Level 111 9.2.6 Level IV Deriving a forward Consumer Price Index (CPI) curve for Level I1 and I11 markets 9.3.1 Piecewise linear continuous function in CPI space 9.3.2 Piecewise linear continuous function in inflation space Level I markets in Europe: intraregional Euro-zone inflation spreads Alternative approaches to the construction of inflation curves Asset swaps - connecting swap and bond prices Hedging a swapped new issue 9.7.1 A simple interim hedge 9.7.2 A more precise hedge 9.7.3 A portfolio hedge for net outright inflation risk The evolution of the Euro-zone HICP swap market 9.8.1 Seven lessons from seven months of Euro-zone inflation swap data Historical estimation of price index volatilities Pricing inflation options 9.10.1 Zero percent zero-coupon floors 9.10.2 Year-on-year inflation floors Summary xi 27 1 27 1 27 1 27 1 272 272 273 274 275 277 279 28 1 282 283 284 28 5 286 288 292 293 293 295 10 Conclusion 297 References Bibliography Useful websi t es Index 301 315 317 319