Inflation Derivatives

Inflation Derivatives Ssims 2008 By Shri Krishna Potdar Ashish Sarda Inflation Derivatives Page 2 Inflation Derivatives 1. Introduction This document is about the inflation derivatives and our attempt to understand inflation linked securities. Inflation linked derivatives is a small part of derivatives market but it has shown considerable growth from almost non-existent in early 2001 till date. The primary purpose of inflation derivatives is to transfer inflation risk. As in the case of nominal interest rate market, the advantage of inflation derivative contracts over inflation bonds is that derivatives can be tailored to fit particular client demand more precisely than bond. Our focus is on explaining the basics of inflation derivatives and understands the advantages of inflation derivatives. This report explains inflation-linked swaps and inflation-linked bonds. The reports structured as follows, chapter 2 discusses about the market participants and various inflation derivatives market along with their brief introduction Chapter 3 discusses Inflation and Inflation Indices, Basics and concepts; this includes indexation lag, seasonality, break-even inflation etc. Chapter 4 focuses on the inflation-linked swaps and bonds. This chapter explains zero-coupon inflation swap; which is the basic form of inflation swap, rest are the different portfolios of zerocoupon inflation swaps. Chapter 5 discusses on the Legal, regulatory and accounting issues as per ISDA inflation derivatives definitions. Page 3 Inflation Derivatives 2. The Markets Inflation products attracts diverse group of investors such as banks, pension funds, mutual funds, insurance companies and hedge funds. To hedge inflation-linked retail products banks want to receive inflation on swaps. Insurance companies and pension funds want to receive inflation to match their long-term inflation-linked liabilities. Inflation linked derivative market and different IL products are growing very fast. Following are inflation linked derivative markets 2.1. UK Inflation Derivative Market In the UK inflation derivative market, the pensioners are the major investor in indexed bonds and the government is the major issuer of swaps. Now market is increasingly accompanied by many corporations as the issuer. The key for the long-term sustainability of any derivatives market is the existence of balanced, two-way interest which can be seen in UK market, i.e. interest from pensioners and from government. The index-linked bond market in the UK exists with a regulatory regime that encourages certain pension liabilities to be hedged with index-linked securities. The government, is the main issuer through HM Treasury’s Debt Management Office (DMO), the main groups of investors are pension funds and life insurance companies. The government gives contracts to the private sector players in construction and maintenance of infrastructure projects or new buildings under the Private Finance Initiative (PFI) in the UK. Such contracts are paid with guaranteed income stream for a fixed period of time (usually between 20 and 30 years). Since more than 10% of PFI contracts have specified that the income Page 4 Inflation Derivatives stream paid by the government will be inflation-indexed, such agreements have proved to be a large and steady source of flows to the index-linked market – either through direct bond issuance or through the combination of bank borrowing and an IL derivative hedge. The introduction of the gilt repo market in 1996 was an important development for the derivatives industry in the UK, since it enabled participants to borrow both nominal and indexlinked gilts and so more efficiently hedge both nominal and inflation-indexed swaps. In the second half of 2000 a large number AAA-rated issuers such as the IBRD (International Bank for Reconstruction and Development) EBRD (European Bank for Reconstruction and Development), EIB (European Investment Bank), NIB (Nordic Investment Bank), RFF (Re´seau Ferre´ de France), CDC (Caisse des De´poˆ ts et Consignations), and others entered the indexlinked market in the UK for the first time, encouraged by the strong investor demand from the UK pension and life insurance sectors for ‘eligible’ RPI-linked bonds offering higher real yields than corresponding index-linked gilts. These new bonds were all swapped, since the issuers were ultimately interested only in floating rate (LIBOR) funding, with Barclays Capital and the Royal Bank of continental Scotland as the principal swap counterparts, although a number of continental European and US banks were also involved. These swapped AAA issues have proved to be a simple but effective way for pension funds and insurance companies to gain exposure to higher yielding instruments than the traditional sovereign-issued index-linked gilts. 2.2. The French and Euro-zone markets Inflation-linked derivative markets in France and Euro-zone are considered in these markets. Inflation linked derivative activities in these markets started in year 1998. But market remained small illiquid, confined predominantly to French financial institutions, until the launch of further Page 5 Inflation Derivatives bonds linked to French inflation in 1999. The Euro-HICP ILS market started trading in May 2001. Today, the volume of ILSs transacted with pension funds or corporate issuers has still not reached levels seen in the UK although some transactions in structures designed to hedge infrastructure cash flows have taken place. 2.3. The Dutch Dutch are world leaders in pension assets per capita. A large proportion of their liabilities implicitly linked to inflation. Dutch pension funds are significant investors in the French OATi and OAT€i bonds. They are regularly seen as a group & to be significant participants in the Tre´sor’s indexed bond auctions. Many Dutch rental property contracts specify rents and leases linked to price indices. 2.4. Spain In Spain, several inflation-indexed swap transactions have taken place, initiated in particular by corporations involved in the construction of highways and toll roads, as well as by property companies with rental streams linked to the Spanish CPI. A number of pension fund managers have also been involved in this market as receivers of indexed cash flows. However, the divergence of domestic CPI indices from their Euro-zone counterparts implies a significant basis risk, which has reduced the relative attraction of Euro-zone HICP-linked derivatives to receivers (investors) in Spain. For this reason the market for derivatives linked to domestic inflation has developed further than is the case in many other European countries, even without the existence of government index-linked bonds. Page 6 Inflation Derivatives 2.5. Italy The Italian pension system is a combination of different schemes, the three most important of which are the private sector employers fund, the public sector employers schemes and the selfemployed schemes. Together they cover a total of approximately 20 million active workers and 16 million pensioners, and the pension benefits provided by each are all inflation-indexed, primarily to the Italian CPI. A pool of indexed liabilities of this magnitude naturally leads to strong demand for assets linked to Italian consumer prices and is one of the major factors why the government has begun to issue index-linked bonds. A number of corporations have come to realize that exposure to inflation is desirable and have entered into inflation-indexed swaps. 2.6. The Swedish market The Swedish government launched the current index-linked bond market in 1994, and swap market activity started shortly thereafter. However, the market remains relatively illiquid and limited mainly to local interest, and SEK-denominated swap transactions do not feature regularly in the inter-dealer broker market. Italy has also proven to be the primary source of demand for retail products linked to panEuropean inflation indices. In the two years since its initial issue in May 2001 the Italian Post Office alone has sold more than €2bn of such structures. This demand accelerated further in 2003, in which the first two quarters alone each saw more than €2bn of swapped issuance targeted primarily at retail investors. This also highlights the fact that Euro-zone price indices are seen as valid substitutes for the national index in Italy, which enables the liquid Euro-HICPlinked market to be tapped especially useful when large volumes are required. This trend is likely to be continued across Europe as issuers and investors alike appreciate that the basis risk Page 7 Inflation Derivatives between domestic and pan-European measures of inflation is at least partially offset by the superior liquidity available for the latter, and that over time the individual inflation measures are likely to converge further. 2.7. Non-European markets A healthy ILS market has existed for many years in Australia. A small but fast-growing ILS market has developed in South Africa where demand from pension funds is met by issuance linked to infrastructure projects as well as some limited corporate-paying interest Australia’s first indexed security was a CIB linked to the Australian CPI. The security was issued by the State Electricity Commission of Victoria in August 1983. Several years later, in July 1985 the Commonwealth Government department issued four treasury indexed bonds (TIBs), two CIBs and two interest indexed bonds (IIBs). The government had several motivations: • Provision of cost effective financing. • Prolonging the average maturity of government debt. • Enhancement of the retirement incomes policy. From 1987 quasi-government authorities entered the market and in 1988 annuity style indexed securities were issued. The Australian Treasury resumed its issuing in 1993 and in 1997/1998 the Australian Treasury increased its auctions. The reason for this increase was to provide greater certainty of the timing of the auctions. As a consequence investors could enhance the planning of their acquisitions of TIBs. Another change introduced in 2001 was the indexlinked auction calendar. This calendar would be announced at the start of each financial year. The auction dates were chosen to directly follow the TIB coupon payment dates to aid coupon reinvestment. Page 8 Inflation Derivatives The top 15 investors in the market together hold 90% of the total amount outstanding and are domestic funds and insurance companies. The Commonwealth government department, representing half the securities, is the dominant issuer of Australian indexed bonds. Other issuers are state governments, quasi-government authorities, electricity companies and financiers of private projects. In general the IIBs are linked to the Australian CPI. Both CIBs and IIBs have coupon payments on a quarterly basis, with cash flows indexed to the average percentage change in the CPI over the two quarters ending in the quarter that is two quarters prior to that in which the next interest payment falls. A number of government agencies, corporations and municipalities have issued inflationindexed securities since 1997. Swaps have played an important role in this process, since most issuers don’t want to bear the inflation risk incorporated in the instruments. Thus they have used the derivatives market to swap inflation risk for nominal rate risk. It is not likely to be a coincidence that the majority of non Treasury issues are IIBs, a structure that is better suited to swap inflation risk for nominal interest rate risk compared with the structure of TIIN. There have been a handful of corporate indexed issues since 1997. This indicates that there is only limited demand. An explanation is that it is plausible that risk-averse investors demand an instrument that removes credit as well as inflation risk. Page 9 Inflation Derivatives 3. Inflation and Inflation Indices, Basics and concepts 3.1. What is Inflation Inflation is a situation in economy where, there is more money chasing less of goods and services. In other words it means there is more supply or availability of money in the economy and there are less goods and services to buy with that increased money. Thus goods and services command higher price than actual as more people are willing to pay a higher value to buy the same goods. In this inflationary situation, there is no real growth in the output of the economy per sector. It’s simply more money chasing few goods and services. 3.2. Basic types of inflation 3.2.1. Demand-Pull Inflation Demand-pull inflation places responsibility for inflation squarely on the shoulders of increases in aggregate demand. This type of inflation results when the four macroeconomic sectors (household, business, government, and foreign) collectively try to purchase more output that the economy is capable of producing. In terms of the simple production possibilities analysis, demand-pull inflation results when the economy bumps against, and tries to go beyond, the production possibilities frontier. Then end result is inflation. In more elaborate aggregate market analysis, demand-pull inflation results when aggregate demand increases beyond aggregate supply creating economy-wide shortages. As with market shortages, the price (or price level) rises. Then end result is inflation. Page 10 Inflation Derivatives 3.2.2. Cost-Push Inflation Cost-push inflation places responsibility for inflation directly on the shoulders of decreases in aggregate supply that result from increase in production cost. This type of inflation occurs when the cost of using any of the four factors of production (labor, capital, land, or entrepreneurship) increases. In terms of the production possibilities analysis, this means that the production possibilities frontier is shrinking closer to the origin, causing it to bump down against the aggregate demand. Then end result is inflation. In the aggregate market analysis, aggregate supply decreases to less than aggregate demand creating economy-wide shortages; As with any market shortages, the price (price level) rises. Then end result is inflation. 3.3. The Inflation Rate and the Price Level The inflation rate is the percentage change in the price level. The formula for the annual inflation is Before going deep in understanding of Inflation linked products, it is essential to know how market measures inflation. 3.4. Consumer Price Index (CPI) CPI is the most commonly used measure for the inflation. CPI is the price of weighted average basket of consumer goods. Inflation linked bonds (ILBs) cash flow payments are commonly Page 11 Inflation Derivatives calculated using CPI. Other used price indices are Wholesale Price Index (WPI), Export price index, earning indices and GDP deflator. The good choice of inflation index is the index which matches investors’ assets and liabilities in the best possible way. Wholesale Price Index (WPI) -- This measures the different prices of a basket of commodities in the wholesale markets. The basket is broadly made up of Primary products, Fuel products, and manufactured products. GDP Deflator --This is used to adjust measure of gross domestic product for inflation. Mainly used consumer Price Indices are as follows TIPS: Treasury Inflation-Protection Securities; Page 12 Inflation Derivatives CPI-U: Consumer Price Index for All Urban Consumers; IL: Index linked; OATs: Obligations assimilables du Tre´sor; HICP: Harmonized Index of Consumer Prices 3.5. Inflation-Linked Derivatives Inflation-Linked Derivatives are instruments with their values depending on the underlying inflation. These could be instruments like: inflation swaps, inflation swaptions, and inflation caps. Inflation-Linked Swaps (or simply Inflation Swaps) are most often used and very appropriate in order to act as a hedge against inflation. Inflation-linked (IL) derivatives are financial products used by entities, such as sovereigns, state and local governments, financial institutions and corporations, to manage the risks associated with variable rates of inflation. Inflation derivative works in the same way as that of Interest Rate Swaps (IRSs) and other interest rate derivatives and provides flexibility to the underlying inflation-indexed bond markets and opened up opportunities to achieve financial objectives unavailable through the use of indexed bonds in isolation. Inflation derivatives market has been grown exponentially since year 2000; and is growing very fast. 3.6. Why Inflation Derivative? Inflation Derivatives in the market offer many opportunities to market participants: to transfer risk, access increased liquidity, optimize market timing, meet portfolio hedging requirements, Page 13 Inflation Derivatives customize cash flows, effect market arbitrage and create hybrid structures (e.g., inflationprotected equity or credit-linked bonds). Inflation Derivative facilitates the execution of strategies that are cheaper and more efficient than those available in using the bond market and helps participants to meet needs that the bond market is unable to satisfy. Inflation derivative provides more facilities for issuers and investors. To meet the requirements of investors and issuers, Inflation derivatives can be used to bridge mismatches in maturity, timing, index, profile and size. To bridge Mismatch in maturity: Different maturity periods can be matched by the banks or financial institutions as per requirements from issuer or payers e.g. a financial intermediary can synthetically convert an issuer’s 10-year bond into a 15-year maturity issue by swapping out the issuer’s cash flows and thereby assuming the maturity mismatch risk, which will provide the investor the desired maturity. For example, demand for short-dated index-linked corporate bonds can be weak in the UK, particularly in relation to other forms of debt from the same issuer. A corporate borrower can exploit any such mismatch through the combination of a short-dated Floating Rate Note (FRN) with a real versus LIBOR swap, for example, to achieve its desired index-linked maturity. Timing: An issuer can achieve an attractive break-even inflation rate through the use of a real versus fixed (nominal) rate swap to help optimize timing. In many markets, break-even inflation rates have tended to display a mean-reverting pattern over time. A borrower may wish to take advantage of perceived market distortions and lock in wide break-even inflation rates through the use of a real versus fixed rate swap and subsequently issue an underlying security as and when it is convenient to do so. Page 14 Inflation Derivatives Index: With IL derivative it is easy for a corporate issuer, with the price Inflation-indexed Securities index of a single European country, can tap the more liquid Euro-zone inflationindexed market through a swap from one index into another. This is one of the best opportunities for investors. Profile: Many liability structures tend to match a constant real annuity. Such structures most closely reflect the profile of an amortizing bond. However, investors are often more interested in standard bullet issues, for which pricing and secondary market trading is more straightforward. IL swaps can be employed to swap out an issuer’s bullet index-linked issue and so convert the debt profile to an annuity structure, thereby more closely matching the issuer’s expected cash flows. Size: An issuer may fall short of the amount it wishes to raise through a particular index-linked bond issue. For example, there may be limited interest in its long-dated inflation-indexed bond issues due to investor preferences for holding a diverse set of issuers by name and by industry group. In such cases an issuer might cover the shortfall by selling a fixed nominal rate bond and use the overlay of a real-fixed swap to effectively achieve the desired size of exposure to real rates. 3.7. Inflation Payers (Issuers) In inflation derivative an instrument is the combination of investor (or receiver) demand and issuer (or payer) need for such exposure, combined with the ability and willingness of financial intermediaries to take basis risk in order to bring the two sides together. Sovereigns and utility companies are the examples of payers. As their income is linked to inflation, they are ideally suited to pay inflation in the inflation market. Now we will see how debt issuers can utilize the Page 15 Inflation Derivatives IL derivatives markets to modify or complement existing bond issuance. There are three classes of derivative solutions for inflation payers. 1 Standard derivative solution for Inflation-linked (IL) issuers 2 Private Finance Initiative (PFI) projects in the UK 3 UK housing associations The simplest option open to issuers is to sell standard ‘‘bullet’’ profile bonds. Payers of index-linked cash flows typically have a net exposure to an IL income stream. Very often this exposure is a steady stream of future cash flows (as is the case in the vast majority of rental or lease agreements) which are constant in real terms and, as such, resemble a real rate annuity. In such cases it is often appropriate to hedge this steady stream of future inflation-indexed cash flows with a structure to pay index-linked flows to the market. Arguably, all index-linked income streams or earnings are of this form and can be managed through the issuance of a series of bullet structures to cover the full range of exposed maturities. However, in many cases such structures do not perfectly match the issuer’s expected cash flows, and so this section begins with a discussion of the various derivative solutions appropriate in these situations. The concepts introduced are also applicable to non-bullet issues, although amortizing and other more bespoke bond designs are described separately here based on practical applications related to examples drawn from the UK market, in which infrastructure projectrelated IL structures have become commonplace. The UK government’s Project Finance Initiative has been widely applied with over £35bn of capital-spending projects already approved, and similar initiatives have been implemented or are under consideration in other countries. Page 16 Inflation Derivatives Finally, property lease and rental-related income structures are considered, in which annual increases in lease or rental payments are often implicitly or explicitly linked to inflation. The standard solution is to bring a new issue targeted explicitly at a series of investors, typically with an investment bank as lead manager for the issue, or through a group of banks acting as ‘co-leads’ Another scenario is where investors have only a limited requirement of bonds from a particular issuer, due to credit exposure considerations. There are possibilities that investor might have already be overweight bonds issued by a particular industry or they might be more generally constrained with respect to securities with the same credit rating. An issuer with inflation-indexed future income may be able to tap the wider market for conventional or floating rate bonds to satisfy its immediate funding requirements, although it would still fall short of its desired index-linked exposure. However, through the additional overlay of a real versus nominal (fixed or floating) swap the issuer can effectively transform its nominal bond into an IL liability and thereby synthetically create an index-linked issue to achieve its full objective. This concept is illustrated in Figure below Page 17 Inflation Derivatives Frequent issuers, such as AAA-rated sovereign issuers, try to exploit investor demand for AAA-rated IL payers. They have to pay inflation plus real rate cash flows to their investors. However, since a hedging bank can bear the inflation risk or wants to obtain the position that the sovereign issuer can provide, the hedging bank can offer a swap to the AAA-rated issuer. This inflation swap comprises paying the real rate plus inflation by the hedging bank and receiving nominal floating from the AAA-rated issuer. The stream of cash flows paid and received by the financial intermediary are similar. The combination of both figures above illustrates how, by entering into both swaps, the bank can neutralize its index-linked exposure. All that remains is to hedge the remaining fixed versus Page 18 Inflation Derivatives floating risk by entering into a vanilla Interest Rate Swap (IRS), and the whole package is illustrated in figure below Above figure shows how issuers, investors and investment banks work in inflation derivatives market. It also shows the streams of cash flows between them. It is the ideal scenario in which the notional amounts roll dates and maturities perfectly match. So the intermediary banks have to do very little work to do except to manage any small difference in the real coupons on the two opposing swaps. But in reality, the maturity, timing and notional size are rarely matched exactly, so the investment bank is required to warehouse some or all of the risks associated with such discrepancies. For achieving maximum profit from inflation derivative, a utility or other corporate issuer may want to obtain a profitable level of break-even inflation rates available in the market prior to the proposed date of a formal debt sale. In the UK, break-even inflation rates have typically varied around the 2.5% level, which is also the Bank of England’s target for inflation. This variation mostly reflects supply and demand conditions but also reflects the general state of the economy and other factors. A corporate treasurer who believes that this mean-reverting nature of Page 19 Inflation Derivatives break-even rates will continue is likely to perceive value inherent in issuing with break-even inflation rates above 2.5%, and the existence of inflation swaps allows these terms to be ‘locked’ prior to actual issuance. The transaction of a real versus fixed swap will lock in any break-even level for any such issuer and can be unwound subsequently, when the indexed bond is brought to market. On the investor side of the structures, several variations can also take place. For example, an investor may wish to enter into a real versus fixed swap directly with the investment bank, rather than purchase a swapped issue. The investor thereby gains exposure to generic inflation risk and is left free to invest in fixed rate nominal paper from a wider pool of issuers, including AAA issuers. In general, the swaps between the hedging banks and the pension funds or insurance companies are covered by collateralization agreements to reduce the credit exposure risk of both parties. Consider a corporate issuer that wants to lock-in a profitable level of BEI rates available in the market prior to the formal debt issuance of the sovereign issuer. The transaction of a real against nominal swap will lock in any break-even level for any issuer. Alternatively entering into nominal against real swaps by the corporate issuer, matching the maturities and coupons of already issued nominal bonds, will synthetically achieve the same result. On the investor side several variations can take place. An investor can enter into a real versus nominal swap with the hedging bank directly, rather than purchase a swapped issue. The investor thereby gains exposure to inflation risk and is left free to invest in fixed rate nominal securities on its own. Page 20 Inflation Derivatives Important to note, swaps with big notional amounts, for example between hedging banks and pension funds or insurance companies, are covered by collateralization agreements to reduce the credit exposure risk of both parties. 3.8. Inflation Receivers Inflation derivatives reflect the balance of demand from investors and the supply by issuers. There are two main sources of demand for inflation derivatives from investors as their liabilities are linked to inflation; they are ideally suited to receive inflation in the inflation market: • • Pension fund managers, who seek to hedge their inflation-indexed liabilities. The retail sector, which is attracted by equity products with real principal guarantees and/or inflation plus fixed interest products. Inflation products attract a diverse group of investors such as banks, pension funds, mutual funds, insurance companies and hedge funds. Banks want to receive inflation on swaps to hedge inflation-linked retail products. Insurance companies and pension funds want to receive inflation to match their long-term inflation-linked liabilities. Generally pension liabilities are linked to a cost of living index for their scheme participants. Not surprisingly many pension funds have investments in ILBs. Inflation derivatives provide alternative strategies for pension fund managers than the option of purchasing ILBs to match inflation linked liabilities. Mismatches in maturity, index, profile and size can be overcome with the use of inflation derivatives resulting in a more precise hedge. In general pension funds tend to apply inflation derivatives when real rates are neither high nor low. The retail investment market is another important group of inflation receivers. Though most people invest in inflation-linked cash flows via their pension schemes, many investors prefer to Page 21 Inflation Derivatives additionally invest directly in inflation-linked securities. Investors were keen to buy equity linked notes if downside protection was provided. 3.9. Seasonality Inflation is subject to recurring pattern over the course of year and so the CPI. Consumer behavior exhibit seasonal features; in many industrialized countries consumer spending goes up to Christmas, which often followed by price discounting in January; then demand for energy and warm cloths is higher in the cold winter months than in the summer and so on. To the extent that such behavior causes prices to fluctuate this should in turn be reflected by seasonal movements in the consumer price indices. Government behavior can also influence these cycles Existence of Seasonality complicates the analysis of inflation-linked bond prices. There are significant advantage in a well-established index being employed, but such indices often exhibits seasonal pattern. Potential solution for this is to use a seasonally adjusted price index, but in general such series is less understood. Choice of a seasonal price index leads to two issues; expected nominal size of future cash flows will be impacted by their timing with respect to the seasonal pattern, and yields quoted using standard market convention will also be impacted. 3.10. Indexation Lag Indexation is a technique used to adjust income payments by means of a price index. In inflationindexed securities board links the coupons and principal to an index ratio of customer price index. This ratio is given by (CPI maturity/ CPI issue). Where maturity is the date of maturity of bond and issue is the date of issue of bond. Page 22 Inflation Derivatives In reality there are many inflation indices and they all have some measurement bias; because of this none of the indices are immediately available; thus there is always an indexation lag. In practice, the value of the index is not known for the cash flow date and lagged index value is taken. To achieve high degree of real value certainty, the indexation lag is adjusted in such a way that the value of bond, at the time of maturity will not be affected by the inflation. For last few months of maturity of bonds, inflation rates of pervious months is used; so investors have no proper protection in last few months of maturity. Inflation over lag period differs from the inflation in perfect inflation period. Indexation lag is unavoidable. Region France Italy Euro-zone USA UK Index Euro-area HICP ex Tobacco Euro-area HICP ex Tobacco Euro-area HICP ex Tobacco US CPI UK RPI Time Lag 3 Months 3 Months 3 Months 3 Months 8 Months Page 23 Inflation Derivatives Inflation linked bond usually pay coupons; if there is a trading of bond between coupon dates, then sellers are being compensated for holding the bond for part of the coupon period. This compensation is effected via the payment of accrued interest. Accrued interest is calculated as per the cumulative movement in the associated inflation index. Linear interpolation is used to calculate (daily) reference numbers; these reference numbers are the inflation index values of two or three months ago, i.e. the reference number for the first of any calendar month equals the calendar months three months earlier. I(01-Mat-08)=CPI(Feb-08),I(01-Jun-08)=CPI(Mar-08) and so on. Daily Reference number can be calculated as below I(dd/mm/yy)=I(01/mm/yy) + Where, [I(01/mm+1/yy)-I(01/mm/yy)] DiM-number of days in the month for Page 24 Inflation Derivatives This daily reference number is used to quote inflation-linked bond in the standard manner. This time lag in inflation linked bonds (ILBs) causes hedging errors, which is undesirable when precise hedging is needed; but when maturity increases the negative effect because of the timelag on inflation hedge decreases. 3.11. Nominal Yield and Real yield Investors care about the goods and services money can buy, not money itself. People prefer an increase in income and no increase in prices, than doubling the income and doubling the prices. The consumer market consists of broad verity of products, a basket of goods and services is constructed that tries to represent the basket of goods and services used by a representative customer. An inflation index is the relative value of the basket. A base date is chosen at which nominal value of the index is set to 100. If the nominal value of the basket equals $10,000 at the base date it means index will rise by 1 point if the basket value increases by $100. Example 1 Let us assume an investor’s asset equals to $100,000. An investor can currently buy 10 baskets with his/her asset; index is 100 during this time. After a year index has increased to 102 (i.e. the cost of basket has increased to 10,200). This means inflation is 2% (=102/100 – 1). Along with increase in the index, nominal value of the assets of the investor has increased to $101,000. Nominal change = = +1.00% Page 25 Inflation Derivatives Real change = = - 0.98% Even though the value of investor’s assets grew in nominal terms (+1.00%), in real terms his/her asset have decreased (-0.98%). Example 2 We assume that current index equals 100 the market trades inflation linked zero coupon bond at 98.08% and nominal bond at 97%, both with a time to maturity equals to 1 year. Nominal yield on nominal zero-coupon bond: Real yield on inflation linked zero-coupon bond: Given the growth of inflation index, we can calculate the real yield on a nominal bond and nominal yield on an inflation linked bond. Assume that inflation index grows to 102. Real yield on nominal zero-coupon bond: Nominal yield on inflation linked zero-coupon bond: Page 26 Inflation Derivatives 3.12. Breakeven inflation (Spread between Nominal and real yield) Breakeven inflation is the difference between nominal yield on fixed rate investment and the real yield on an inflation linked investment of similar maturity and credit equality. If average inflation is more than the break even, the inflation linked investments outperform the fixed rate and if inflation averages below the break even the fixed rate investments outperforms. Break-even inflation = comparable fixed rate – inflation linked real yield In theory calculating Break-even inflation from simply subtracting real yield from a nominal yield is crude from of properly compounded calculation. Breakeven for a market with an annual yield ; Where bei is break-even inflation For semi-annual market Where ‘n’= yield on nominal bond And ‘r’ = yield on inflation-linked bond Page 27 Inflation Derivatives 4. Inflation Derivatives 4.1. What is Inflation Derivative? Inflation Derivatives are contracts which payoff is often derived from an agreement. This agreement is often expressed in a mathematical formula based on price movement in CPI or inflation linked securities. Inflation derivatives enable investors and issuers to overcome mismatches in maturity, timing, index, profile and maturity. 4.2. Inflation Swaps An inflation swap is an agreement to swap a fixed percentage for the realized inflation rate as a percentage. Both percentages are based on the same notional amount. Inflation swaps can have terms as long as 50 years. Among inflation derivatives, inflation swaps have wide range of application. Inflation swaps are more preferred over Inflation linked Bonds (ILB) because of following reasons • • • • More flexible risk structure Negotiable maturity Wider choice of CPI Avoidance of residual risk. Page 28 Inflation Derivatives Overview of Inflation swap Investment banks give quote to the trader to trade inflation swap. Inflation swaps are traded in the over the counter market, not on exchanges. Bank provides quote for the fixed side of the swap. Basic Example of Inflation Swap Page 29 Inflation Derivatives 4.3. Break-Even rate (B/E Rate) Over the term of the swap if the inflation rate is same as the fixed rate on average, the two legs will have the same value and swap will break even. Because of this, the fixed leg is also called the break even rate. Page 30 Inflation Derivatives 4.4. Inflation Swaps Widely used inflation swaps are Zero Coupon (ZC) inflation swap – Provide cumulative inflation until maturity with no intermediate payments Page 31 Inflation Derivatives Year-on-year (YOY) inflation swap – It pays annualized inflation index returns. Revenue Inflation swap Unlike a zero coupon inflation swap, a revenue inflation swap has multiple inflation linked cash flows. At the end of each period (usually a year) it pays the cumulative inflation form a base month up to the period. Thus, Inflation swaps are bilateral contracts that enable investor or hedger to secure inflationprotected return with respect to an inflation index. The inflation buyer (also known as inflation Page 32 Inflation Derivatives receiver) pays a predetermined fixed or floating rate. In return, the inflation buyers receives from the inflation sellers (also called as inflation payers) inflation linked payment(s). Inflation swaps are basically different portfolios of zero-coupons inflation swap. Many applications exists for inflation swaps, some of them are as below Hedging/ Asset Liability Management • Inflation swaps can be used to hedge concentrations of inflation risk. This is especially useful for pension funds that have inflation-linked liabilities. • Inflation swaps can be used to hedge inflation exposures that are not traded in the cash markets • It is impractical for banks to hedge inflation risks using inflation-linked bonds. Even if twoway liquidity can be found, it imposes heavy balance sheet charges. Investing • Inflation swaps are an unfunded way to take a view on inflation. This allows for leverage and helps those with a high funding cost. • An inflation swaps are customizable over-the-counter products, investors can tailor the inflation exposure to match their precise requirements in terms of index (e.g. many schemes are linked to domestic wage indices), timing, maturity, size and so on. Page 33 Inflation Derivatives • • Inflation swaps can be used to go either long or short inflation on a reference index. Investors may not be allowed to sell an inflation-linked asset due to regulatory restrictions, but may be allowed to enter in an inflation swap paying inflation. Arbitrage/Trading • • It is usually easier to pay inflation on an inflation swap than to short an inflation-linked asset. Traders can take advantage of price dislocation between the cash and derivatives market by buying the cash asset and paying inflation or selling the cash asset and receiving inflation and trading the swap spread to hedge to government vs. curve spread. 4.5. Inflation Linked Bonds (ILB) An Inflation linked Bond (ILB) is a bond which provides protection against inflation, since principal amount of such bonds is indexed to inflation. The coupon payment for ILB is lesser than the fixed rate bonds with a comparable maturity. But in case of ILB, as the principle amount grows, the payment increases with inflation. All ILBs are linked to Inflation, however the precise provision vary around the world. Most often, the outstanding principle is adjusted in response to changes in the Consumer Price Index (on daily basis). In general, the principal and interest payments on an inflation-linked bond rise with any substantial increases in the consumer prices so that the bonds cash flow increases in line with a rise in inflation. 4.5.1. How ILB works? Page 34 Inflation Derivatives ILBs are commonly tied to inflation although the precise provisions vary around the world; e.g. in UK outstanding principle is adjusted in the response to changes in the retail price index. In general, the interest payments and principal on an inflation linked bond rise along with any widespread increase in the consumer price so that the bond’s cash flows increase with a corresponding rise in inflation. E.g. suppose a $1,000 10-year inflation-linked bond with a 4.0% annual real coupon purchased in 2008- in an environment of 8% hypothetical annual inflation – the interest paid would be 4.0% of $1,000, or $40.00. The principal on the bond adjust upward on a daily basis to match the inflation rate, reaching $1,480 at the end of 10-years. Although the coupon rate on the bond remains fixed at 4.0%, the actual interest payments rise as the value of the principal increases and in 2018, the annualized interest payment would be 4.0% of the inflation-adjusted principal or 4.0% of $1,480, which is $59.2 While over the time, there might be an increase in the nominal amount of interest paid on an inflation linked bond; the real value of the interest and principal of an inflation-linked bond actually remains constant. In the above example, the purchasing power of $59.2 in 2018- which is the final interest payment on the bond, would be the same as the purchasing power of $40 in 2008- the initial interest payment. Similarly, the $1,480 received at maturity will purchase the same amount of goods or services, in 2018, as the $1,000 principal purchase in 2008. Thus, inflation-linked bonds are valuable in proving recurring real cash flows to investors by protecting against inflation. Page 35 Inflation Derivatives 4.6. Types of Inflation Linked Bonds 4.6.1. Capital Indexed Bonds (CIBs) CBIs have fixed coupon rates and nominal principal value that rises with inflation. Periodic coupon payments are calculated as the real coupon rate times the inflation-adjusted principal, and the inflation adjusted principal itself is repaid at maturity. Real coupon (1) 4 4 4 4 4 4 4 Inflation rate (2) 6 5.5 5 5 4 3.5 3 Compounded inflation (3) 1.06 1.1183 1.1742 1.2329 1.2822 1.3271 1.3669 Coupon indexation (4) = (5) - (1) 0.24 0.4732 0.6968 0.9316 1.1288 1.3084 1.4676 Redemption payment (6) = 100 * (3) Year 1 2 3 4 5 6 7 Coupon payment (5) = (1) * (3) 4.24 4.4732 4.6968 4.9316 5.1288 5.3084 5.4676 Inflation Uplift Page 36 Inflation Derivatives 8 9 10 4 4 4 3 2.5 2.5 1.4079 1.4431 1.4782 1.6316 1.7724 1.9128 5.6316 5.7724 5.9128 147.82 47.82 4.6.2. Interest Indexed Bonds (IIBs) IIBs pay a fixed coupon plus an indexation of the fixed principal every period. The principal repayment at maturity is not adjusted, i.e. the nominal principal is repaid at par. All the inflation adjustments are made through coupons, which are calculated simple by adding the periodic inflation rate to the coupon rate of the bond. As such, IIBs are often said to pay a margin over inflation and are best viewed as a form of inflation-protected floating rate bond. Page 37 Inflation Derivatives An important distinction between the CIB and IIB structures is that only the former provides for the preservation of future cash flows in terms of purchasing power at the issue date, there by providing the better inflation protection. Year 1 2 3 4 5 6 7 8 9 10 Real coupon (1) 4 4 4 4 4 4 4 4 4 4 Inflation rate (2) 6 5.5 5 5 4 3.5 3 3 2.5 2.5 Principal Indexation (3) = (2) 6 5.5 5 5 4 3.5 3 3 2.5 2.5 Coupon payment Redemption (4) = (1) + payment (3) (5) 10 9.5 9 9 8 7.5 7 7 6.5 6.5 100 Page 38 Inflation Derivatives 4.6.3. Current Pay Bonds (CPBs) CPBs are very similar to IIBs. Like IIBs, the principal repayment at maturity is not adjusted for inflation. However while IIBs pay a fixed coupon with an indexation of the fixed principal every period, CPBs pay both an inflation-adjusted coupon as well as an indexation of the fixed principal. CPB is a type of inflation protected floating rate bond. Year 1 2 3 4 5 Real coupon (1) 4 4 4 4 4 Inflation rate (2) 6 5.5 5 5 4 Coupon indexation (3) 0.24 0.22 0.2 0.2 0.16 Principal Indexation (4) = (2) 6 5.5 5 5 4 Coupon payment (5) = (1) + (3)+(4) 10.24 9.72 9.2 9.2 8.16 Coupon+ Principal Indexation 6.24 5.72 5.2 5.2 4.16 Page 39 Inflation Derivatives 6 7 8 9 10 4 4 4 4 4 3.5 3 3 2.5 2.5 0.14 0.12 0.12 0.1 0.1 3.5 3 3 2.5 2.5 7.64 7.12 7.12 6.6 6.6 3.64 3.12 3.12 2.6 2.6 4.6.4. Indexed annuity Bonds (IABs) IABs consist of a fixed annuity payment and a variable element to compensate for inflation. Year (1) 1 2 Base payment Inflation (2) (3) 12.33 12.33 6 5.5 rate Compounded Inflation (3) 1.06 1.1183 Varying element (4)=(1)*{(3)-1} 0.74 1.46 Total cash Flow (5)=(4)+(1) 13.07 13.79 Page 40 Inflation Derivatives 3 4 5 6 7 8 9 10 12.33 12.33 12.33 12.33 12.33 12.33 12.33 12.33 5 5 4 3.5 3 3 2.5 2.5 1.1742 1.2329 1.2822 1.3271 1.3669 1.4079 1.4431 1.4792 2.15 2.87 3.48 4.03 4.52 5.03 5.46 5.91 14.48 15.2 15.81 16.36 16.85 17.36 17.79 18.24 4.6.5. Indexed Zero coupon Bonds (IZCBs) IZCB consist of single payment of inflation-adjusted principal on redemption no coupon interest is paid. This bond is issued in Iceland, Poland and Sweden. Page 41 Inflation Derivatives Type of Indexed Bond Capital Indexed Bond Interest payments Final payment Interest Indexed Bond Current Pay Bond Indexed Annuity Bond Indexed Zero coupon Bond - Where r = annual real coupon rate (%) = value of the price index when bond is issued = value of the price index at time t =value of the price index at maturity =value of the price index on the penultimate interest payment date Page 42 Inflation Derivatives B =base annuity payment 5. Legal, regulatory and accounting issue 5.1. ISDA inflation derivatives documentation The ISDA has published documentation on inflation definitions supplementing the “ISDA Master Agreements”. The main issues relate to delay and disruption in the publication of the inflation index. 5.1.1. Delay of publication If the reference index has not been published five business days prior to the next payment date for the transaction related to that index, the calculation agent shall use a substitute index level using the following methodology: 1. If applicable, the calculation agent takes the same action to determine the substitute index level as that specified in the terms and conditions of the related bond. The related bond, if any, is specified in the confirmation of the trade. A related bond is typically specified for asset swaps, but not for inflation swaps. Page 43 Inflation Derivatives 2. If point 1. does not result in a substitute index level for the affected payment date the calculation agent determines the substitute index level as follows: substitute index level = Base level × (Latest level / Reference level) where Base level means the level of the index 12 calendar months prior to the month for which the substitute index level (definitive or provisional) is being determined. Latest level means the latest available level (definitive or provisional) for the index. Reference level means the level (definitive or provisional) of the index 12 calendar months prior to the month to which the latest level is referring. If a relevant level is published after five business days prior to the next payment date, no adjustments will be made to the transaction. The determined substitute reference level will be the definitive level for that reference month. 5.1.2. Successor index If, during the term of the transaction, the index sponsor announces that an index will no longer be published or announced but will be superseded by a replacement index specified by the index sponsor, and the calculation agent determines that the replacement index is calculated using the same or similar methodology as the original index, this index is deemed the successor index. 5.1.3. Cessation of publication If an index has not been published for two consecutive months or if the index sponsor (publisher) has announced that it will no longer publish the index, the calculation agent shall determine a successor index for the purpose of the transaction using the following methodology: Page 44 Inflation Derivatives • If a successor index has been designated by the calculation agent pursuant to the terms and conditions of the related bond, such successor index shall be designated a successor index hereunder. • If no related bond exists, the calculation agent shall ask five leading independent dealers to state what the replacement index shall be. If three or more dealers out of at least four responses state the same index, this index will be deemed the successor index. If, out of three responses, two or more dealers state the same index, this index will be deemed the successor index. If no successor index has been decided following responses from dealers by the third business day prior to the next payment date or by the date that is five business days after the last payment date (if no further payment dates are scheduled), the calculation agent determines an appropriate alternative index. This alternative index will be deemed the successor index. If the calculation agent determines that there is no appropriate alternative index, a termination event occurs and both parties are affected parties as defined in the 2002 ISDA Master Agreement. 5.1.4. Rebasing the index If the calculation agent determines that the index has been or will be rebased at any time, the rebased index will be used from then on. However, the calculation agent shall make adjustments pursuant to the terms and conditions of the related bond, if any. If there is no related bond, the calculation agent shall make adjustments to the past levels of the rebased index so that rebased index levels prior to the rebase date reflect the same inflation rate as before it was rebased. 5.1.5. Material modification prior to payment date Page 45 Inflation Derivatives If prior to five business days before a payment date an index sponsor announces that it will make a material change to an index, then the calculation agent shall make any adjustments to the index consistent with adjustments made to the related bond. If there is no related bond, only those adjustments necessary for the modified index to continue as the index will be made. 5.1.6. Manifest error in publication If, within 30 days of publication, the calculation agent is notified that the index level has to be corrected to remedy a material error in its original publication, the calculation agent will notify the parties of the correction and the amount payable as a result of that correction. 5.2. Regulation for pension funds An important role in the development of the inflation derivatives market (especially in Europe) will be played by the regulatory frameworks for pension funds in their respective countries. For instance, in the Netherlands, which probably has the most developed European pension industry, the social partners (employers and employees) decided that most pension funds need to provide only conditional indexation. Conditional indexation means that pension funds only need to provide indexation if they have sufficient funds to allow this. Unconditional indexation is a stronger requirement, in which a pension fund guarantees an inflation-adjusted pension. Unconditional indexation schemes would likely have a strong positive impact on the inflation market as demand for inflation products by pension funds would almost certainly increase. So far, no major entities have adopted an unconditional indexation scheme. 5.3. Accounting standards Page 46 Inflation Derivatives In 2005 the European Union adopted the accounting standards as set by the International Accounting Standards Board (IASB). The introduction of these accounting standards obliges all European (including the UK) public companies listed on any exchange in the European Union to prepare their financial accounts following the International Financial Reporting Standards (IFRS). In the derivatives market, all companies are affected via IAS-39, the IFRS standard covering derivatives. The US equivalent to IAS-39, FAS-133, which was introduced several years ago, has more or less similar implications for inflation derivatives by US entities. IAS-39 requires all derivatives to be valued on a mark-to-market basis, which essentially means that they are transferred to the balance sheet. Changes in the mark-to-market valuation will therefore affect profit and loss account of companies, which likely increases volatility in companies’ earnings statements. Only if a company can demonstrate that the derivative is used for hedge accounting purposes, will it need not be value the derivative security on a mark-tomarket basis. For inflation derivatives, this means that companies with inflation-linked cashflows need to demonstrate that an inflation swap is an effective hedge for its inflation-linked cash flows. If companies have cash flows indirectly linked to inflation (e.g. supermarkets) this can be problematic and likely costly. In the inflation derivatives market all companies with defined benefit contributions will also be affected by IAS-19, which prescribes the accounting and disclosure for employee benefits (that is, all forms of consideration given by an enterprise in exchange for service rendered by employees). The principle underlying all of the detailed requirements of the Standard is that the cost of providing employee benefits should be recognized in the period in which the benefit is earned by the employee, rather than when it is paid or payable. Therefore, companies are required to mark-to-market the value of indexation schemes. Page 47 Inflation Derivatives In the UK the national Accounting Standards Board (ASB) published its Financial Reporting Standard, which obliges all public companies listed on the London Stock Exchange to apply similar standards. Although some differences exist between IAS-19 and FRS-17, the bottom line remains the same; assets and liabilities should be valued on a market instead of actuarial basis. The introduction of the above accounting standards is likely to result in more volatile financial statements than before. This will especially be the case for companies whose assets and liabilities are not well matched. This makes inflation derivatives particularly interesting for pension funds with indexation schemes. By including inflation derivatives in their investment portfolio, companies are able to match their inflation-linked liabilities more closely. This can significantly reduce the volatility of their financial statements. References: • Mark Deacon, 2004, Inflation-Indexed Securities Bonds, Swaps & other Derivatives, England, John Wiley & Sons, Ltd • Jeroen Kerkhof, 2005, Inflation Derivatives Explained Markets, Products, and Pricing, US, Lehman Brothers • John C Hull, 2007, Options, Futures and other derivatives, New Jersy, Prentice hall Web References: www.isda.org www.barcap.com/inflation Page 48 Inflation Derivatives www.ingpit.com http://www.innovative-investor.com/copublished_article.pl?article=11 http://www.bls.gov/CPI/#publications http://www.lehman.com/ http://retail.standardlifeinvestments.com/content/search.html?client=my_frontend&output =xml&query=swaps&site=retail http://retail.standardlifeinvestments.com/content/gars/training_modules.html http://www.fincad.com/support/developerFunc/mathref/InflationDerivs.htm http://www.ml.com/index.asp?id=7695_7696_8149_74412_77220_77428 http://www.allianzinvestors.com/commentary/edu_education03022005.jsp http://www.inflationdata.com/inflation/ http://epp.eurostat.ec.europa.eu/portal/page?_pageid=1090,30070682,1090_33076576&_da d=portal&_schema=PORTAL www.mth.kcl.ac.uk http://www.livemint.com/SectionPages/Money-Matters.aspx?NavId=2 Page 49