Inflation expectations

OTA used standard financial techniques to obtain estimates of the cost of capital in the pharmaceutical industry as a whole and the cost of capital for pharmaceutical R D investments in particular. We relied on techniques and data provided in a contract report by Stuart Myers and Lakshmi Shyam-Sunder (285). The cost of capital varies over time and across firms, but over the past 15 years the cost of capital in the pharmaceutical industry as a whole varied in the neighborhood of roughly 10 percent after adjusting for investors inflation expectations (see appendix C). 

Prototypes Provide ability to use product, typically in a fairly limited sense. Very powerful and compelling approach to involving potential users. Relatively expensive and not fuUy portable sometimes lead to inflated expectations. 

Therefore, the inflation expectation could be assumed comparing the yield of a conventional bond to the yield of an inflation-linked bond with similar maturity. This average inflation expectation is known as break-even inflation rate and is given by Fisher s equation (6.1) ... 

Therefore, the yield spread is around 2% reflecting the expected inflation during the life of the bond. A higher inflation expectation will mean a greater spread between inflation-linked and conventional bonds. 

Traditionally, information on inflation expectations has been obtained by survey methods or theoretical methods. These have not proved reliable however, and were followed only because of the absence of an inflation-indexed futures market. Certain methods for assessing market inflation expectations are not analytically valid for example, the suggestion that the spread between short- and long-term bond yields cannot be taken to be a measure of inflation expectation, because there are other factors that drive this yield spread, and not just inflation risk premium. 

Equally, the spread between the very short-term (overnight or 1 week) interest rate and the 2-year bond yield cannot be viewed as purely driven by inflation expectations. Using such approaches to glean information on inflation... 

As above, assuming a constant average inflation rate, which is then used to calculate the value of the bond s coupon and redemption payments. The duration of the cash flow is then calculated by observing the effect of a parallel shift in the zero-coupon yield curve. By assuming a constant inflation rate and constant increase in the cash flow stream, a further assumption is made that the parallel shift in the yield curve is as a result of changes in real yields, not because of changes in inflation expectations. Therefore, this duration measure becomes in effect a real yield duration ... 

A repeat of the above procedure, with the additional step, after the shift in the yield curve, of recalculating the bond cash flows based on a new inflation forecast. This produces a duration measure that is a function of the level of nominal yields. This measure is in effect an inflation duration, or the sensitivity to changes in market inflation expectations, which is a different measure to the real yield duration ... 

In Chapter 11 of the author s book The Bond and Money Markets, we show some approaches used to measure inflation expectations, with reference to the United Kingdom index-linked gilts. To recap, these measures include ... 

The break-even inflation expectation, where average inflation expectations are estimated by comparing the return oti a conventional bond against that on an indexed bond of similar maturity, but including an appUcatimi of the compound form of the Fisher identity. This has the effect of decomposing the nominal rate of return on the bond into comprments of real yield and inflation ... 

This section follows the approach (with permission) from Deacon and Deny (1994), a highly accessible account. This is their Bank of England working paper, Deriving Estimates of Inflation Expectations from the Prices of UK Government Bonds . 

Using the modified Waggoner method described in Chapter 5, the nominal spot yield curve for the gUt market in July 1999 is shown in Figure 6.5. The real term stmcture is also shown, which enables us to draw the implied forward inflation expectation curve, which is simply the difference between the first two curves. 

In essence, the real yield curve can and should be used for all the purposes for which the nominal yield curve is used. Provided that there are enough liquid index-linked bonds in the market, the real term stmcture can be estimated using standard models, and the result is more valid as a measure of market inflation expectations than any of the other methods that have been used in the past. 

The first step for estimating future streams is to know the expected inflation. To do this, the procedure needs the future trend of index in which the inflation expectation is built. The inflation expectation determined by countries is based on a different basket of products and services. For instance, inflation-linked bonds issued in the United Kingdom or UK index-linked gilts, are linked to the Retail Price Index (RPI) inflation-linked bonds issued in the United States or TIPS are linked to the Consumer Price Index (CPI). Table 6.1 summarizes the key global inflation indices used by the major issuers of inflation-linked bonds. 

The first step determines the binomial inflation rate tree according to the inflation expectations. The binomial tree is used for pricing a hypothetical annual... 

We have already described the notion of bond trading in three dimensions, thanks to the availability of linkers. Perhaps the most important aspect of this 3D trading is the ability to implement a view with much greater precision. Often, when trades are done in nominals, they really reflect a view on inflation, bnt because nominal yields do not just represent inflationary expectations, this is an imprecise enactment of that view. With inflation-linked bonds, investors can express a much purer inflation expectation. 

Inflation-linked bonds enable investors to hedge the effects of inflation. These instruments allow investors to implement their views on the inflation expectations for a particular economy. 

Accepting that developed, liquid markets, such as that for Treasuries, are efficient, with near-perfect information available to most if not all participants, then the inflation expectation is built into the conventional Treasury yield. If the inflation premium understates what certain market participants expect, investors will start buying more of the index-linked bond in preference to the conventional bond. This activity will force the indexed yield down (or the conventional yield up). If, on the other hand, investors think that the implied inflation rate overstates expectations, they will buy more of the conventional bond. 

Observing the trading patterns of a liquid market in inflation-indexed bonds enables analysts to draw conclusions about nominal versus real interest rates and to construct an inflation term structure. Such analysis is problematic, since conventional and indexed bonds typically differ considerably in liquidity. Nevertheless, as explained above, it is usually possible to infer market estimates of inflation expectations from the difference between the yields of the two types of bonds. 

The main drawback with this basic technique is that it requires conventional and index-linked bonds of identical maturity. Using bonds with merely similar maturities compromises the results. In addition, the bonds yields will be influenced not only by inflation expectations but by liquidity, taxation, indexation, and other considerations as well. There is also no equivalent benchmark (or on-the-run) indexed security. 

Deacon, M., and A. Derry. 1994. Deriving Estimates of Inflation Expectations From the Prices of U.K. Government Bonds. Bank of England Working Paper no. 23, July. 

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