Inflation Indexed Securities

_ _ Inflation-indexed Securities Bonds, Swaps and Other Derivatives Second Edition Mark Deacon Andrew Derry and Dariush Mirfendereski _ _ Inflation-indexed Securities Wiley Finance Series Inflation-Indexed Securities: Bonds, Swaps and Other Derivatives, 2nd Edition Mark Deacon, Andrew Derry and Dariush Mirfendereski European Fixed Income Markets: Money, Bond and Interest Rates Jonathan Batten, Thomas Fetherston and Peter Szilagyi (Editors) Global Securitisation and CDOs John Deacon Applied Quantitative Methods for Trading and Investment Christian L Dunis, Jason Laws and Patrick Naı¨ m (Editors) Country Risk Assessment: A Guide to Global Investment Strategy Michel Henry Bouchet, Ephraim Clark and Bertrand Groslambert Credit Derivatives Pricing Models: Models, Pricing and Implementation Philipp J Scho¨nbucher Hedge Funds: A Resource for Investors Simone Borla A Foreign Exchange Primer Shani Shamah The Simple Rules: Revisiting the Art of Financial Risk Management Erik Banks Option Theory Peter James Risk-adjusted Lending Conditions Werner Rosenberger Measuring Market Risk Kevin Dowd An Introduction to Market Risk Management Kevin Dowd Behavioural Finance James Montier Asset Management: Equities Demystified Shanta Acharya An Introduction to Capital Markets: Products, Strategies, Participants Andrew M Chisholm Hedge Funds: Myths and Limits Franc¸ois-Serge Lhabitant The Manager’s Concise Guide to Risk Jihad S Nader Securities Operations: A Guide to Trade and Position Management Michael Simmons Modeling, Measuring and Hedging Operational Risk Marcelo Cruz Monte Carlo Methods in Finance Peter Ja¨ckel Building and Using Dynamic Interest Rate Models Ken Kortanek and Vladimir Medvedev Structured Equity Derivatives: The Definitive Guide to Exotic Options and Structured Notes Harry Kat Advanced Modelling in Finance Using Excel and VBA Mary Jackson and Mike Staunton Operational Risk: Measurement and Modelling Jack King Interest Rate Modelling Jessica James and Nick Webber _ _ Inflation-indexed Securities Bonds, Swaps and Other Derivatives Second Edition Mark Deacon Andrew Derry and Dariush Mirfendereski Published 2004 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (þ44) 1243 779777 Copyright # 2004 Mark Deacon, Andrew Derry and Dariush Mirfendereski Email (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on www.wileyeurope.com or www.wiley.com All Rights Reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed to permreq@wiley.co.uk, or faxed to (þ44) 1243 770620 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold on the understanding that the Publisher is not engaged in rendering professional services If professional advice or other expert assistance is required, the services of a competent professional should be sought Other Wiley Editorial Offices John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books Library of Congress Cataloging-in-Publication Data Deacon, Mark Inflation-indexed securities : bonds, swaps and other derivatives / Mark Deacon, Andrew Derry, and Dariush Mirfendereski — 2nd ed p cm.—(Wiley finance series) Previously published: London: Prentice Hall Europe, 1998 Includes bibliographical references and index ISBN 0-470-86812-0 (cloth : alk paper) Bonds Government securities Bond market Indexation (Economics) Inflation (Finance) I Derry, Andrew II Mirfendereski, Dariush III Title IV Series HG4651.D4 2004 2003021827 332.63 2044—dc22 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0-470-86812-0 Typeset in 10/12pt Times by Originator, Gt Yarmouth, Norfolk Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production _ 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 Acknowledgements xxiii xxv Disclaimer xxvii List of Abbreviations xxix What 1.1 1.2 1.3 Are Inflation-indexed Securities and Derivatives? A historical perspective How indexed bonds work The role of derivatives 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 1 9 11 16 17 18 18 19 21 22 23 23 24 vi Contents 2.3 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 39 40 Why Invest in Indexed Debt? 3.1 Reducing inflation risk 3.2 Relative stability of returns 3.3 Performance relative to conventional bonds and equities 3.4 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 43 43 44 46 49 51 52 53 55 55 55 56 58 58 Why Issue Indexed Bonds? 4.1 Why governments issue indexed bonds 4.1.1 Reducing borrowing costs: the role of inflation expectations 4.1.2 Reducing borrowing costs: saving the inflation risk premium 4.1.3 Risk management 59 59 2.4 2.5 2.6 2.7 39 59 61 64 Contents 4.1.4 4.1.5 4.2 4.3 4.4 Inflation-indexed bonds and monetary policy Maintaining long-term capital markets in difficult economic conditions Why private corporations issue indexed bonds The relative scarcity of index-linked bonds Summary vii 65 66 66 67 71 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 convexity 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 73 74 75 Major International Indexed Bond Markets 6.1 Australia 6.1.1 A brief history of indexation in Australia 6.1.2 The structure of the Commonwealth Treasury Indexed Bond (TIB) market 6.2 Canada 6.3 France 6.3.1 The history of indexation in France 6.3.2 The introduction of inflation-indexed OATs (Obligations assimilables du Tre´sor) 6.3.3 Indexation to pan-European inflation – OAT¼ci bonds 6.4 Sweden 6.4.1 The formation of the Swedish government index-linked bond market 6.4.2 The development of the market toward international standards 6.4.3 Recent developments 6.5 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 6.6 United States of America 6.6.1 A brief history of indexation in the USA 93 94 94 77 79 80 81 82 83 85 85 89 92 99 100 106 106 107 113 119 119 120 124 128 128 136 138 141 141 viii Contents 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 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 OAT¼ci 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 Other 7.1 7.2 7.3 Indexed Bond Markets Argentina Austria Bolivia 142 148 151 160 160 160 161 162 162 163 163 163 165 165 167 167 167 168 168 169 169 169 171 171 171 172 173 174 176 176 177 177 177 179 180 182 182 References 313 UK Debt Management Office (2003a) Consultation Meetings with GEMMs [Gilt Edged Market Makers] and Gilt Investors: 20 January 2003 (Screen announcement, 21 January) UK Debt Management Office (2003b) Quarterly Review, April United Kingdom Parliament (2003) House of Lords Debate on Private Finance Initiatives, 12 February, Column 663 US General Accounting Office (2000) Consumer Price Index: Update of Boskin Commission’s Estimate of Bias (Report to the Ranking Minority Member, Committee on Finance US Senate, GAO/GGD-00-50, February) Wade, T (1998) Fed’s TIPS purchases raise eyebrows on Street Bond Week, Volume XVIII, No 50, 14 December Waggoner, D (1997) Spline Methods for Extracting Interest Rate Curves from Coupon Bond Prices (Federal Reserve Bank of Atlanta Working Paper Series No 97–10) Weiner, S.E (1983) Why are so few financial assets indexed to inflation? Federal Reserve Bank of Kansas City Economic Review, May, 3–18 Wilcox, D and Zervos, D (1994) Extracting Real Interest Rates and Inflation Expectations from the UK Gilt Market (Federal Reserve Board mimeo, October) Wilson Committee (1980) Report of the Committee to Review the Functioning of Financial Institutions (the Wilson Report), chapters and 17 Wojnilower, A.M (1997) Inflation-indexed Bonds: Promising the Moon New York: The Clipper Group, March Woodward, G.T (1988) Comment: The real rate of interest: Inferences from the new UK indexed gilts International Economic Review, Volume 29, No (August), 565–568 Woodward, G.T (1990) The real thing: A dynamic profile of the term structure of real interest rates and inflation expectations in the United Kingdom, 1982–1989 Journal of Business, Volume 63, No 3, 373–398 Wynne, M.A and Rodriguez-Palenzuela, D (2002) Measurement Bias in the HICP: What Do We Know and What Do We Need to Know? (Federal Reserve Bank of Dallas Working Paper No 0206) Yariv, D (1994) Market-based Inflationary Expectations as an Indicator for Monetary Policy: The Case of Israel (Bank of Israel mimeo) Yariv, D (1997) Indexation and debt management Government Debt Management Workshop at the Centre for Central Banking Studies, 30 April _ _ Bibliography _ Bach, G.L and Musgrave, R.A (1941) A stable purchasing power bond American Economic Review, Volume 31, December, 823–835 Barro, R.J (1974) Are government bonds net wealth? Journal of Political Economy, Volume 82, No 6, 1095–1117 Barro, R.J (1979) On the determination of the public debt Journal of Political Economy, Volume 87, No 6, Part 1, 940–971 Bohn, H (1988) Why we have nominal government debt? Journal of Monetary Economics, Volume 21, January, 127–140 Bohn, H (1990) A positive theory of foreign currency debt Journal of International Economics, Volume 29, 273–292 Fleetwood, W (1707) Chronicon Preciosum: An Account of English Money, the Price of Corn and Other Commodities for the Last Six Hundred Years Friedman, M (1974) Using escalators to help fight inflation Fortune, July, 94–97 and 174–176 Tobin, J (1963) An essay on the principles of debt management Commission on Money and Credit, Fiscal and Debt Management Englewood Cliffs, NJ: Prentice-Hall, pp 143–218 _ _ Useful Websites _ Country Organisation Website address Australia Australian Financial Markets Association (AFMA) Australian Office of Financial Management (AOFM) Commonwealth Treasury Central Bank of Bolivia Ministry of Finance Bank of Canada Department of Finance Central Bank of Chile Ministry of Finance Central Bank of Colombia Ministry of Finance and Public Credit Czech National Bank Ministry of Finance Copenhagen Stock Exchange National Bank of Denmark Ministry of Finance Agence France Tre´sor (AFT) Caisse d’Amortissement de la Dette Sociale (CADES) German Finance Agency Ministry of Economy of Finance Hungarian Debt Management Agency Icelandic Bonds (hosted by the National Debt Management Agency) Iceland Stock Exchange Kaupthing Bank Reserve Bank of India Barclays Capital Economic Derivatives Site Economics Departments, Institutes and Research Centers in the World (EDIRC) International Swaps and Derivatives Association (ISDA) MTN-i Merrill Lynch Housing Finance Agency Bank of Israel Ministry of Finance Department of the Treasury Ministry of Finance Statistics Bureau www.afma.com.au Bolivia Brazil Canada Chile Colombia Czech Republic Denmark Finland France Germany Greece Hungary Iceland India International Ireland Israel Italy Japan www.aofm.gov.au www.treasury.gov.au www.bcb.gov.bo www.fazenda.gov.br www.bankofcanada.ca www.fin.gc.ca www.bcentral.cl www.minhda.cl www.banrep.gov.co www.minhacienda.gov.co www.cnb.cz www.mfcr.cz www.xcse.dk www.nationalbanken.dk www.vm.fi www.aft.gouv.fr www.cades.fr www.deutsche-finanzagentur.de www.mof-glk.gr www.allampapir.hu www.bonds.is www.icex.is www.kaupthing.net www.rbi.org.in www.barcap.com www.economicderivatives.com netec.mcc.ac.uk/EDIRC www.isda.org www.mtn-i.com www.ml.com www.hfa.ie www.bankisrael.gov.il www.mof.gov.il www.dt.tesoro.it www.mof.go.jp www.stat.go.jp 318 Useful Websites Kazakhstan Mexico New Zealand Peru Poland South Africa Sweden Turkey UK USA Ministry of Finance National Bank of Kazakhstan Ministry of Finance and Public Credit: Investor Relations Office New Zealand Debt Management Office Reserve Bank of New Zealand Central Reserve Bank of Peru COFIDE Ministry of Finance National Bank of Poland Bond Exchange of South Africa (BESA) Rand Merchant Bank (RMB) National Treasury Statistics Sweden Swedish National Debt Office Central Bank of the Republic of Turkey Bank of England Glas Cymru National Savings & Investments (NS&I) Office of National Statistics UK Debt Management Office (DMO) United Kingdom Parliament Bureau of Labor Statistics Bureau of the Public Debt Chicago Board of Trade (CBOT) Federal Reserve Bank of Dallas Federal Reserve Bank of New York General Accounting Office www.minfin.kz www.nationalbank.kz www.shcp.gob.mx www.treasury.govt.nz/nzdmo www.rbnz.govt.nz www.bcrp.gob.pe www.cofide.com.pe www.mf.gov.pl www.nbp.pl www.besa.za.com www.rmb.co.za www.treasury.gov.za www.scb.se www.rgk.se www.tcmb.gov.tr www.bankofengland.co.uk www.dwrcymru.com www.nsandi.co.uk www.statistics.gov.uk www.dmo.gov.uk www.parliament.the-stationery-office.co.uk www.bls.gov www.publicdebt.treas.gov/bpd/bpdhome.htm www.cbot.com www.dallasfed.org www.ny.frb.org www.gao.gov _ Index accounting standards, changes to 260 Act on the Limitations on the Use of Index Clauses (1994) (Finland) 194 Agricultural Mortgage Bank (Denmark) 193 AI bonds (Denmark) 192 ajustabonos (Bonos Ajustables del Gobierno Federal) (Mexico) 211 AMBAC Inc 252 Anchor Savings Bank 142 Anderson, Roger 154 Anglian Water 66 arbitrage boundary 280 Argentina 180–1 BARRA 181 Bonos Generales de Ahorro Ajustable 180 Consumer Price Index (CPI) 180 Convertibility Law (1991) 181 hyperinflation 4, 180 Valores Nacionales Ajustables (VNAs) 180–1 VAVIS 181 ARIMA time-series model 87 auctions 36–8 consistency with other instruments 37–8 cost-effectiveness and market development 37 pricing 37–8 Australia Capital Indexed Bond (CIB) 36–7, 94, 95, 96, 99, 160–1 Commonwealth Government Securities (CGS) 98–9 Credit Foncier Bonds (CFBs) 94 history of indexation 94–100 ILS market 244–5 Indexed Annuity Bonds (IABs) 94 Interest Indexed Bonds (IIBs) 94–5, 99 Treasury Corporation of Victoria (TCV) Indexed Annuity Bond 35 Treasury Indexed Bonds (TIBs) 44, 94, 96, 97, 99–100 Austria 182 Austrian Electricity Authority 182 _ Banca IMI 208 Banco Ambrosiano 208 Bank of England 10, 14, 237 Bank of England Inflation Term Structure 62, 91 Bank of Israel 203 Bank of Israel Law 202 Bank of Japan 209 Banque Nationale de Paris 109 Barclays Capital 109, 111, 113, 141, 241 indices 93 BARRA (Argentina) 181 Barro, Robert 4, 136 Barro-style index-linked gilts 29, 40–2 basis risk 10 beat-neutral trading strategies 78 Berner Kantonalbank 225 beta 77–9, 270 BG Transco 66 bid-ask spreads 54 Birch, Bill 213 Bitsberger, Timothy 151, 153 Black-Scholes framework 295 BNP 111 Bolivia 182 Bond Market Association of America 245 bondes (Mexico) 211 bonos (Mexico) 211 Bonos Banco Central en Pesos (Chile) 187 Bonos Banco Central en UF (BCUs) (Chile) 188 Bonos de Unidades de Inversio´n or udibonos (Mexico) 211 Bonos Generales de Ahorro Ajustable (Argentina) 180 bootstrapping 277 borrowing costs, reduction in inflation and 59–61 inflation risk premium and 61–4 Boskin bias 111 Boskin Commission Risk 145 Boskin Report 1997 11, 12, 109, 143 Brash, Donald 213 320 Index Brazil 182–6 hyperinflation index adjustment 29 National Treasury Notes (NTN-Cs) 184–6 National Treasury Obligations (OTNs) 184–6 partial indexation 31 Portaria 229 183 Readjustable National Treasury Obligations (ORTNs) 182–4 Treasury bonds (BTNs) 184–6 break-even inflation rate 6, 81–2 Brisa-Auto Estradas de Portugal SA (BRISA) 219 Brown, Gordon 75, 130 Building Cost Index (BCI) (Iceland) 198 Buoni Poliennali del Tesoro (BTP) bonds (Italy) 208, 244, 271 Bureau of Labor Statistics (BLS) 12 CADES (Caisse d’Amortissement de la Dette Sociale) 110, 115, 242 CADESi issues 111–12, 271 Caisse des De´poˆts et Consignations (CDC) 241 Caisse Nationale des Autoroutes (CNA) 116, 242 callable bonds 34 Canada break-even inflation rates 81–2 indexed bonds 100–6 Real Return Bond (RRB) 13, 27, 44, 81, 82, 100–5, 109, 127, 162–5, 299 Registered Retirement Savings Plans (RRSPs) 104 Canadian Depository for Securities (CDS) 103 Capital Indexed Bond (CIB) 17–18, 196, 245 reinvestment risk 24 real return 25 taxation 25 duration 23 Capital Indexed Bond (CIB) (Australia) 93, 94, 95, 96, 99 auction of 36–7 calculation of interest payments 160–1 calculation of settlement price 161 cash flow calculations for 160–1 Capital Indexed Bond (CIB) (Hungary) 196 Capital Indexed Bond (CIB)-style swaps 262–4 capital-indexed structure CDC Marche´s 111 Central Bank of Bolivia 182 Central Bank of Chile 186, 187–8 Central Bank of Iceland 198 Certificati del Tesoro Reali (CTR) bonds (Italy) 16, 63, 207–9 cetes (Mexico) 211 Chicago Board of Trade (CBOT) 70, 121, 153–4 Chicago Mercantile Exchange (CME) 261 Chile 186–8 Bonos Banco Central en Pesos 187 Bonos Banco Central en UF (BCUs) 188 Pagare´ Reajustables Pago Cupones (PRCs) 186–7 Pagare´s Descontables del Banco Central (PDBCs) 187 Pagare´s Reajustables del Banco Central (PRBCs) 186–7 Unidad de Fomento (UF) 186 Christiansen Corporation 142 Clinton, Bill 142 COI bond (Poland) 218–19 Collor I Plan (Brazil) 184 Colombia 188–9 IIBs 188 TES-UVR bonds, calculation of settlement price 228–9 Unidad de Poder Adquisitivo Constante (UPAC) 188 UVR (Real Value Unit) 188 Commonwealth Government Securities (CGS) 98–9 Consumer Price Index (CPI) 6, 9, 13, 27, 49, 63, 75, 271, 279 Argentina 180 Austria 182 Core 10 Iceland 198–9 for IL derivatives 272–5 Ireland 203 South Africa 220 Consumer Price Index (CPI) curve for IL derivatives 272–5 piecewise linear continuous function in CPI space 273 piecewise linear continuous function in inflation space 274–5 Consumer Price Index for All Urban Consumers (CPI–U) 10, 12, 88, 143 Index conventional bonds, performance of indexed bonds relative to 46–9 convertible bonds 35 convexity 6, 62, 63 Core CPI 10 Corporacio´n Financiera de Desarrollo SA (COFIDE) 216 Cost of Living Index (CLI) (Iceland) 198 cotton bonds 141 coupon-bearing bonds 170–1 Cox, Ingersoll and Ross (CIR) model 88 Cre´dit Agricole Indosuez 111 Credit Foncier Bonds (CFBs) (Australia) 94 Credit Support Annex (CSA) agreement 254 Credit Terms Index (CTI) (Iceland) 198 Cruzado Plan (Brazil) 184 Current Pay Bond (CPB) 19–20, 21 Czech Republic 189–91 DANE (Departamento Administrativo de Estadı´ sticas) 188 Danish Ship Credit Fund 192 Debt Management Office (DMO) (UK) 12, 141, 132–5, 136–7, 240 Defined Benefit (DB) pension schemes 260 deflation 297 deflation floor 30, 109, 154, 256, 258, 294–5 dematerialised security 190 Denmark 191–3 AI bonds 192 I bond 192 IE bonds 192 IJ bonds 192 IS bonds 192 SI bonds 192, 193 Deposit Guarantee Board (IGN) (Sweden) 125 Depreciation Notes’ indexation formula 2–3 derivatives, role of 7–8 Deutsche Bank 113, 154, 258 double-duration 78 duration of bonds 23–4 double-78 of indexed bonds 51 of inflation-indexed bonds 77–9 Earnings-linked Gilts (EGs) 10 Economic Derivatives programme 258 Economic Special Powers Act (1968) (Finland) 193–4 321 EEC Unit of Account 107 efficient frontier analysis 49 Electrolux 128 Employment Cost Index (ECI) 10 Endesa 224 equities as alternative to indexed bonds 56–8 performance of indexed bonds relative to 46–9 EURIBOR 208 euro 63–4 Euro-HICP 11, 108, 118, 194, 195, 208–9, 298 index 275 indexed bonds 113, 115, 116 swap market 285–7 European Bank for Reconstruction and Development (EBRD) 241 European Central Bank 113, 236, 294–5 European Investment Bank (EIB) 30, 140, 241 European Monetary Union (EMU) 194 Eurostat 108, 111, 275 Euro-zone MUICP inflation index 113 Evelyn, Sir George Shuckburgh Exchange Rate Mechanism (ERM) 90 exchange rates 233 Fabius, Laurent 113 Federal Reserve Bank of New York 148 Finance Acts (Denmark) 192, 193 Finland 4, 193–4 Fisher, Irving 4, 141–2 Fisher equation 77, 91 Fisher identity 80, 81, 82 fixed bond 19 Fleetwood, Bishop William Floating Rate Notes (FRNs) 55, 236 France history of indexation 106–7 IL derivatives 242–5 indexation to pan–European inflation 113–19 inflation index inflation-indexed securities programme 64 Livret A savings schemes 109 Obligations Assimilables du Tresor (OATs) 81, 107–13, 113–19, 165–7 price stabilisation programme Rentes Giscard bond 11, 29, 107 Rentes Pinay bond 106 Franklin Savings Association 142 Franzen, Thomas 120 322 Index Friedman, Milton FRS-17 260 FSA Insurance Co 252 Fuerza Ele´ctrica de Catalun˜a 224 Fysikhuset Stockholm 128 Galil bonds (Israel) 204–5, 230 Garban-Intercapital 258 GDP deflator 6, 9, 10, 27 Gensler, Gary 148 Germany 194 Gilboa bonds (Israel) 204, 205 Gilt-edged Market Maker (GEMM) 133 gilts, returns on 44, 45–6 Glas Cymru (Welsh Water) 66 ‘Gold Clause’ Joint Congressional Resolution (1933) (USA) 68–9 Goldman Sachs 154, 258 government bonds 16 Greece 194–5 State Bonds Index Linked (SBIL) 194–5 Greek Government Board (GGB) 271 Greenspan, Alan 65, 145 Harmonised Index of Consumer Prices (HICP) 7, 75 see also Euro-HICP Heath, Jarrow and Morton (HJM) model 88, 279 hedge ratios 77–9 hedging a swapped new issue 281–5 interim hedge 282–3 more precise hedge 283–4 portfolio hedge for net outright inflation risk 284–5 Helms Amendment (1977) (USA) 69 Holding Period Returns (HPRs) 46, 60 housing associations (UK) 252–3 Housing Authority Bonds (Iceland) 199, 200 Housing Bonds (Iceland) 199, 200 Housing Finance Agency (HFA) (Ireland) 201–2 Hungarian Debt Management Agency (A´KK) 195, 196, 197 Hungary 195–8 Capital Indexed Bond (CIB) 196 hyperinflation Argentina 4, 179 Brazil, Chile, Israel 55 Mexico IAS–19 260 I-Bonds 298 Denmark 192 USA 52–3 Iceland 198–201 Building Cost Index (BCI) 198 Consumer Price Index 198–9 Cost of Living Index (CLI) 198 Credit Terms Index (CTI) 198 Housing Authority Bonds 199, 200 Housing Bonds 199, 200 indexed bonds 21–2 Indexed Zero-Coupon Bonds (IZCBs) 199 Investment Credit Funds (ICFs) 198 National Debt Management Agency (NDMA) 199 RIKB 201 RIKS 201 Treasury Indexed Bonds, calculation of settlement price 228–30 Treasury notes 198 Wage Index (WI) 198 IE bonds (Denmark) 192 IG GEMMs 133 IJ bonds (Denmark) 192 IL derivatives (Italy) 256 Immo-Bank AG 35, 182 index factor 16 Index Linked New Zealand Government Stocks (ILNZGSs) (New Zealand) 213 index-linked yield curve 82–3 index mismatching 55, 69 Index of General Market Prices (IGP–M) (Brazil) 184 index ratio 28, 102 indexation lag 26–9, 77, 127 Indexed Annuity Bond (IAB) 21 Australia 94 base annuity payment calculation 39 indexed bond cash flow structures 23, 24 indexed security, definition Indexed Zero-Coupon Bond (IZCB) 22, 288 duration 24 Iceland 199 indexation lag and 28 reinvestment risk 24 Sweden 120, 126 taxation 25 India 201 Industrifinans Naeringseiendom Asa 216 Index inflation bonds and 67–8 break-even rates 81–2 indexation of index-linked bonds to 74–5 measures of expectations 80–5, 89–92 reduction in borrowing costs and 59–61 inflation-adjusted cost of finance inflation-adjusted coupon 19 Inflation Adjusted Savings Bonds (IASBs) (New Zealand) 213 inflation-guaranteed retail products 255–7 inflation-indexed bonds application to cash flows 26–31 full or partial indexation 29–31 and monetary policy 65 New Zealand 214–15 inflation-indexed securities, definition Inflation-Indexed Treasury Securities (IITS) (Kazakhstan) 210 Inflation Linked (IL) derivatives alternative approaches to the construction of inflation curves 277–9 asset swaps 279–81 Consumer Price Index (CPI) curve for 272–5 definition 235–6 definition of pricing 269–70 future trends 259–61 inflation payers 246–55 inflation receivers (investors) 255–8 levels of pricing 271–2, 272–5 Level I markets 271, 275–7 Level II markets 271 Level III markets 271 Level IV markets 272, 295 markets 2003 237–9 early history 239–40 French and Euro-zone 242–4 Non-European 244–6 Swedish 244 UK 240–2 US 245 pricing approaches 269–72 purpose of 236–7 standard derivative solutions for IL issuers 247–50 combined matched hedging 248–9 standard approach 247 swapped index-linked bond issuance 247, 248 323 synthetic index-linked bond issuance 247, 248 Inflation Linked (IL) retail products 255–7 inflation-linked swap (ILS) markets 272 inflation options 258–9 embedded in indexed bonds 258 standalone, in the OTC market 258–9 Inflation-Plus CDs (USA) 142 inflation risk, reduction of 43–4 inflation risk premium and bond convexity 83–5 reduction in borrowing costs and 61–4 inflation swaps to hedge pension liabilities 255 to mitigate credit exposure 253–5 inflation term structure 82–3 inflation term structure model (Bank of England) 62, 91 INSEE 108, 111 Interest Indexed Bond (IIB) 18–19 Australia 93, 99 Colombia 188 duration 23 real return 25 reinvestment risk 24 Interest Indexed Bond (IIB)-style swaps 264, 265 interest rate parity equation 278–9 Interest Rate Swap (IRS) 235, 248, 270 International Bank for Reconstruction and Development (IBRD) 241 Investment Credit Funds (ICFs) (Iceland) 198 Investor AB 128 IR bond (Poland) 217–18 Ireland 201–2 IS bonds (Denmark) 192 Israel 202–6 CPI inflation rates 203 Galil bond 204–5, 230 Gilboa bond 204, 205 Housing Finance Agency (HFA) 201–2 indexed bond market 15 inflation-indexed bonds, calculation of real yields 230–1 Kfir bond 204, 205, 230–1 New Gilon bonds 205 New Kfir bonds 205 nominal bonds 67–8 partial indexation 31 Sagi bonds 204–5, 230 Shahar bonds 205 324 Index issuer LIBOR Spread (LS) 282 issuer Real Spread (RS) 282 Istituto Italiano di Credito Fondiario 208 Italy 207–9 Buoni Poliennali del Tesoro (BTP) bonds 208, 244, 271 Certificati del Tesoro Reali (CTR) bonds 16, 63, 207–9 ILs 256 ITPS 113 Japan 209–10 Jensen’s inequality 84, 85, 90, 91, 278 Jevons, W Stanley JGB (Japanese Government Bond) 209 JHM Acceptance Corporation 142 Jolivet, Benoit 110 JP Morgan 195 KAF 125 Kazakhstan 210 Keynes, John Maynard 4, 128 Kfir bonds (Israel) 204, 205, 230–1 KommuneKredit 193 Landesbank Baden-Wu¨rttemberg 194 Le Lorier, Anne 110 legality of indexed bonds 68–9 Lemierre, Jean 112 Lesotho Highlands Water Project 221 LIBOR 236, 241, 242, 255, 270, 274 Limited Price Indexation (LPI) 30, 44, 67, 258 bonds 30–1, 137, 140 liquidity 53–4 indexed bonds and 70–1 premia Livret A savings schemes (France) 109 local expectations hypothesis 84 London International Financial Futures and Options Exchange (LIFFE) 137 long-term capital markets, maintaining 66 Lowe, Joseph Luzerner Kantonalbank 225 Marshall, Alfred Massachusetts bills of public credit MBIA Inc 252 MCC-Capitalia 208 Medium Term Notes (MTNs) 242, 256–7, 258, 280, 286, 287 Melbourne Cricket Club indexed bonds 99 Mexico 210–12 ajustabonos (Bonos Ajustables del Gobierno Federal) 211 bondes 211 bonos 211 Bonos de Unidades de Inversio´n or udibonos 211 cetes 211 hyperinflation petrobonds 210 tesobonos 211 Unidad de Inversio´n (UDI) 211 Minimum Funding Requirement (MFR) 139–40 modified duration 77 monoline insurers 252 Monte dei Paschi di Siena 208 Morgan Stanley 208 Mortgage Credit Act (Denmark) 192 MUICP 113 Musgrave, Richard Nafinsa 210 National Bank of Greece 195 National Bank of Kazakhstan 210 National Bank of Poland 217 National Consumer Price Index (NCPI) (Mexico) 211 National Debt Management Agency (NDMA) (Iceland) 199 National Debt Savings Accounts (Sweden) 128 National Treasury Notes (NTN-Cs) (Brazil) 184–6 National Treasury Obligations (OTNs) (Brazil) 184–6 Netherlands 212 New Gilon bonds (Israel) 205 New Kfir bonds (Israel) 205 New Zealand 212–15 Index Linked New Zealand Government Stocks (ILNZGSs) 29, 213 Inflation Adjusted Savings Bonds (IASBs) 213 Inflation-Indexed Bond 214–15, 231–2 nominal (or cash) return to maturity Nominal Dirty Price (NDP) 273 Non-gilt Linker Index 141 Nordic Investment Bank (NIB) 241 Norway 215–16 Index Obligations Assimilables du Tre´sor (OAT) bonds (France) 7, 81, 107–13, 113–19, 256, 258 calculation of interest payments 167 calculation of redemption payment 167 calculation of settlement price 167 indexing process 165–6 OATi and OATeuroi bonds, cash flow calculations 165–7 options on indexed bonds 34–5 Over The Counter (OTC) option prices 256, 261 Pagare´ Reajustables Pago Cupones (PRCs) (Chile) 186–7 Pagare´s Descontables del Banco Central (PDBCs) (Chile) 187 Pagare´s Reajustables del Banco Central (PRBCs) (Chile) 186–7 pan-European inflation index Pannon GSM 197 pension reforms in Europe 259–60 Pensions Act (1995) (UK) 30, 43, 140 Peru 216 phantom income risks 33–4 Poland 216–19 COI bonds 218–19 indexed bonds 21–2 IR bond 217–18 PPJ 217 RP bond 217–18 Portaria 229 183 Portugal 219 Posta Vita 256 PPJ bond (Poland) 217 Premium Pension Authority (PPM) (Sweden) 124 price index bias 11 choice of 9–17 definition changes and data revisions 11–13 integrity 13–15 matching 9–10 reliability and integrity 11–16 seasonality 15–16 volatilities 287–92 price stabilisation programmes pricing 36–7 inflation options 292–5 Private Finance Initiative (PFI) 139, 240, 250–1, 299 325 private sector issues of indexed bonds 66–7, 69–70 property as alternative to indexed bonds 58 Purchasing Power Parity (PPP) 50 puttable bonds 34–5 R189 bond (South Africa) 220–1, 223 R198 bond (South Africa) 221–4 Radcliffe Report (1959) (UK) 67 Rand Kardex Company 141 Rand Merchant Bank 221 rational expectations hypothesis 84 Readjustable National Treasury Obligations (ORTNs) (Brazil) 182–4 real-adjusted cost of finance real annuity swaps 264, 265 real gross redemption yields 75–7 real interest rates analysis 85–8 measures 74–80 Real Plan (Brazil) 184 Real Return Bond (RRB) (Canada) 13, 27, 44, 81, 82, 101–5, 109, 127, 162–5, 299 calculation of interest payments 163 calculation of redemption payment 163 calculation of settlement price 163–5 cash flow calculation 162–5 indexing process 162–3 real return to maturity real value certainty 6, 297 Real Yield Securities (REALS) (USA) 142 reference CPI 102 Registered Retirement Savings Plans (RRSPs) (Canada) 104 reinvestment risk 6, 24 Rentes Giscard bond (France) 11, 29, 107 Rentes Pinay bond (France) 106 Republic of South Africa (RSA) government inflation–linked bonds (South Africa) 220 Re´seau Ferre´ de France (RFF) 116, 118, 241, 242 Reserve Bank of New Zealand 213 Retail Prices Index (RPI) 10, 12, 14, 15, 67, 75, 129, 240, 271 inflation 44 RPIX 75, 130, 249 RPIY 75 return relative stability of 44–6 total 49–51 326 Index RIKB (Iceland) 201 RIKS (Iceland) 201 Riksbank 119, 124 risk risk management 64–5 Roseboro, Brian 150–1 Royal Bank of Scotland 241 Royal Commission on National Debt and Taxation RP bond (Poland) 217–18 RPIX 75, 130, 249 RPIY 75 Sagi bonds (Israel) 204–5, 230 SAIL bonds (South Africa) 220 Sandor, Richard 154 Scrope, G Poulett Series I-Bonds (USA) 156–7 SG Investment Banking 113 Shahar bonds (Israel) 205 Sharpe ratio 49 SI bonds (Denmark) 192, 193 Skandinaviska Enskilda Banken (SEB) 120 Snam Rete Gas 243 Socie´te´ Ge´ne´rale 109, 111 South Africa 219–24 auction of indexed bonds 37 CPI 220 inflation–linked bonds 11 R189 bond 220–1, 223 R198 bond 221–4 Republic of South Africa (RSA) government inflation–linked bonds 220 SAIL bonds 220 Spain 224 Special Purpose Vehicle (SPV) 250 Standard Corporate and Merchant Bank (SCMB) 220 standard inter-dealer broker market structures 264, 266–7 State Bonds Index Linked (SBIL) (Greece) 194–5 Statens Bostadsfinansieringsinstitut 128 Stochastic Differential Equations (SDEs) 291 Strauss-Kahn, Dominique 107–8, 112 stripping of indexed bonds 26–7 STRIPS (Separate Trading of Registered Interest and Principal of Securities) 25 sum of hybrid product 256 Summers, Lawrence 145 Svenska Handelsbank 119 swap spread 242 swapped index-linked bond issuance 247, 248 Sweden cash flow calculation for Treasury bonds 168–71 indexing process 168–9 interest payments 169 redemption payment 169 settlement price 169–71 Deposit Guarantee Board (IGN) 125 development toward international standards 120–4 formation of index–linked bond market 119–20 IL derivatives 244 National Debt Savings Accounts 128 Premium Pension Authority (PPM) 124 recent developments 124–8 Swedish National Debt Office (SNDO) 119–20, 121–4, 127–8 indexed zero-coupon bonds (IZCBs) 120, 126 Swedish Nuclear Waste Fund (KAF) 124 Switzerland 225 Sydney Harbour Tunnel Company indexed bonds 99 synthetic index-linked bond issuance 247, 248 tax regulations 38 effect on indexed bonds 31–4 income accrual rules 33–4 uncertainty post–tax real yields 31–3 taxation 6, 52–3 indirect 13–14 regimes 25 tax system, issuance of bonds and 69 TEC 10 113 term structure of real interest rates 79–80 tesobonos (Mexico) 211 Tesoro 244 TES-UVR bonds, calculation of settlement price (Colombia) 228–9 total return 49–51 Trans Texas Inflation Protectors (TTIPs) 142 Trans-Caledon Tunnel Authority (TCTA) 221 Treasury bills as alternative to indexed bonds 55–6 Treasury bonds (BTNs) (Brazil) 184–6 Treasury Corporation of Victoria (TCV) Indexed Annuity Bond 35 Index Treasury Indexed Bonds (TIBs) (Australia) 44, 94, 96, 97 structure of Commonwealth TIB market 99–100 Treasury Indexed Bonds (Iceland) 228–30 Treasury Inflation-Indexed Note (TIIN) (USA) 143, 148, 151 Treasury Inflation Indexed Securities (TIIS) (USA) 142–59, 298 Treasury Inflation Protected Securities (TIPS) (USA) 44, 61, 63, 81, 88, 92, 127, 142–8, 240, 256, 258, 271 Treasury Notes (Iceland) 198 Trichet, Jean-Claude 108 Turkey 225–6 Turner, John 100 UBS 195 UK cash flow calculation for gilts 171–6 accrued interest 173–4 indexing process 171–2 real yields 174–6 redemption payment 172–3 history of index–linked gilt market 128–36 IL derivatives 240–2 market for non-government index-linked bonds 138–41 national savings bonds 128–9 structure of index-linked gilt market 136–8 unbiased expectations hypothesis 84 Unidad de Fomento (UF) (Chile) 186 Unidad de Fomento de Vivienda (UFV) (Bolivia) 182 Unidad de Inversio´n (UDI) (Mexico) 211 Unidad de Poder Adquisitivo Constante (UPAC) (Colombia) 188 USA cash flow calculation for US Treasury inflation-indexed securities 176–8 indexing process 176–7 interest payments 177 redemption payment 177 settlement price 177–8 Index compiled by Annette Musker 327 CPI-U 143 history of indexation 141–2 Inflation-Plus CDs 142 ILS market 245 inflation-indexed savings bonds (I-Bonds) 52–3 legality of indexed bonds 68–9 Real Yield Securities (REALS) 142 recent developments in market 151–9 Series I-Bonds 156–7 TIIS/TIPS market 142–8 Treasury Inflation-Indexed Note (TIIN) 143, 148, 151 Treasury Inflation Indexed Securities (TIIS) 148–59, 298 Treasury Inflation Protected Securities (TIPS) 61, 63, 81, 127, 240, 256, 258, 271 When-Issued (WI) trading 143 zero-coupon bonds 65 Utility Manufacturing Company 142 UVR (Real Value Unit) (Colombia) 188 Valor Adquisitivo Constante (VAC) (Peru) 216 Valores Nacionales Ajustables (VNAs) (Argentina) 180–1 Variable Roughness Penalty 82 VAVIS (Argentina) 181 Verdi-Spar (Norway) 215–16 Volvo 128 Wage Index (WI) (Iceland) 198 Weighted Average of Eight Capital Cities: All Groups Index 99 When-Issued (WI) trading 37, 143 Wholesale Price Index (WPI) (Turkey) 225 Wilson Report (1980) (UK) 9, 129 winners curse 36 year-on-year inflation floors 294–5 zero-coupon bonds 23, 65, 169–70 zero-coupon swap rates 285 zero percent zero–coupon floors 293 ... 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... _ _ Inflation -indexed Securities Wiley Finance Series Inflation -Indexed Securities: Bonds, Swaps and Other Derivatives, 2nd... 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