Inflation-indexed bonds derivatives

As Deacon and Derry (1998, page 91) states, this problem is exacerbated if the maturity of both bonds is relatively short, because the less time to an indexed bond s maturity date, the greater the impact of its nonindexed component. To overcome this flaw, the break-even rate of inflation is used. This is derived by using the Fisher identity, with the risk premium p set to an assumed figure, such as 0, to relate the yield on the conventional bond to a yield on the indexed bond derived using an assumed initial inflation rate. The result is a new estimate of the expected inflation rate i, which is then used to recalculate the indexed bond s yield. The new yield, in turn, is used to produce a new estimate of the expected inflation rate. The process is repeated until a consistent value for i is obtained. 

Using the prices of index-linked bonds, it is possible to estimate a term structure of real interest rates. The estimation of such a curve provides a real interest counterpart to the nominal term structure that was discussed in the previous chapters. More important it enables us to derive a real forward rate curve. This enables the real yield curve to be used as a somce of information on the market s view of expected future inflation. In the United Kingdom market, there are two factors that present problems for the estimation of the real term structure the first is the 8-month lag between the indexation uplift and the cash flow date, and the second is the fact that there are fewer index-linked bonds in issue, compared to the number of conventional bonds. The indexation lag means that in the absence of a measure of expected inflation, real bond yields are dependent to some extent on the assumed rate of future inflatiOTi. The second factor presents practical problems in curve estimation in December 1999 there were only 11 index-linked gilts in existence, and this is not sufficient for most models. Neither of these factors presents an insurmountable problem however, and it is stiU possible to estimate a real term structure. 

Deacon, M., Derry, A., 2004. Inflation-Indexed Securities Bonds, Swaps and Other Derivates, 2nd ed. lohn Wiley Sons, Chichester. 

Description, in the chapter on inflation-linked bonds, of inflation-indexed derivatives. 

Inflation-indexed derivatives, also known as inflation-linked derivatives or inflation derivatives, have become widely traded instruments in the capital markets in a relatively short space of time. They are traded generally by the same desks in investment banks that trade inflation-linked sovereign bonds, which use these instruments for hedging as well as to meet the requirements of clients such as hedge funds, pension funds, and corporates. They are a natural development of the inflation-linked bond market. 

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