Reinvestment factors

The no-arbitrage condition is set by defining the price of a zero-coupon bond that matures at time T in terms of an accumulation factor B(t) which is the value of a money market account that is invested at time 0 and reinvested at time t at an interest rate of r(t). This accumulation factor is defined as Equation (4.31) ... 

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. 

Large coupon payments are another key factor to watch to assess each country s relative performance, as the investor s domestic bias could favour that part of these payments would come back to the same market. Additionally, by reinvesting these flows (coupons and redemptions) in the same market they come from, the country and credit composition of the bond portfolio would not be altered. 

There are five basic methods of linking the cash flows from a bond to an inflation index interest indexation, capital indexation, zero-coupon indexation, annuity indexation, and current pay. Which method is chosen depends on the requirements of the issuers and of the investors they wish to attract. The principal factors considered in making this choice, according to Deacon and Derry (1998), are duration, reinvestment risk, and tax treatment. 

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