Inflation-linked derivatives

Inflation-linked derivative instruments are now widely traded in the capital markets divisions of investment banks that trade the sovereign inflation-linked bonds. Many smaller banks with regional dominance are also building up their trading capabilities as they rise to meet the increasing demand from their client base for inflation-linked products. 

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. 

The objectives of this chapter are to discuss the benefits of the inflation-linked asset class to both issuers and investors, to provide brief histories and salient characteristics of the different European inflation-linked markets (both bonds and derivatives), and to introduce key analytical and trading concepts. 

So, we have argued, the economics of supply and demand make the risk premium a slippery concept. Bond mathematics now makes matters worse. This new aspect centres on the issue of convexity. We know that a forward curve of implied future short-term nominal rates can be derived from the nominal government bond curve. In principle, a forward curve of implied future short-term real rates can be similarly derived from the inflation-linked bond real yield curve. These two curves, taken together, should imply a future path of inflation, if we can set aside the risk premium for the moment. Unfortunately, that is not the case. 

These derivatives provide additional sources and destinations for inflation-linked flows, lower the barrier to entry, and bring in an expanded universe of market participants. This has, over time, enhanced and made more efficient the underlying bond market. 

The UK market in inflation-linked swaps has existed since the early 1990s. In the last five years, there has been a steady growth in volume and lengthening of maturities. The recent developments in the Eurozone inflation derivatives market show that we can very quickly move from a nonexistent market to a multi-billion Euro market in a matter of a few months. 

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

Inflation derivatives are an additional means by which market participants can have an exposure to inflation-linked cash flows. They can also improve market liquidity in inflation-linked products, as an earlier generation of derivatives did for interest-rates and credit risk. As flexible OTS products, inflation derivatives offer advantages over cash products in certain circumstances. They provide ... 

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. 

The repo market in linkers coexists alongside an old-style stocklending system. Issues seldom stray far from general collateral rates. Index-linked gilts are not strippable, and there is no index-linked futures contract. There is a sterling inflation derivatives market, which... 

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