Inflation-indexed bonds market instruments

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. 

To obtain the price of an inflation-linked bond, it is necessary to determine the value of coupon payments and principal repayment. Inflation-linked bonds can be structured with a different cash flow indexation. As noted above, duration, tax treatment and reinvestment risk, are the main factors that affect the instrument design. For instance, index-aimuity bmids that give to the investor a fixed annuity payment and a variable element to compensate the inflation have the shortest duration and the highest reinvestment risk of aU inflation-linked bonds. Conversely, inflation-linked zero-coupon bonds have the highest duration of all inflation-linked bonds and do not have reinvestment risk. In addition, also the tax treatment affects the cash flow structure. In some bond markets, the inflation adjustment on the principal is treated as current income for tax purpose, while in other markets it is not. 

Certain countries have markets in bonds whose coupon or final redemption payment, or both, are linked to their consumer price indexes. Generally, the most liquid markets in these inflation-indexed, or index-linked, debt instruments are the ones for government issues. Investors experiences with the bonds differ, since the securities were introduced at different times in different markets and so are designed differently. In some markets, for instance, only the coupon payment, and not the redemption value, is index-linked. This makes comparisons in terms of factors such as yield difficult and has in the past hindered arbitrageurs seeking to exploit real yield differences. This chapter highlights the basic concepts behind indexed bonds and how their structures may differ from market to market. 

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