Inflation-linked markets

BNP Paribas is Euromoney’s Best

BNP Paribas is Risk’ Best Structured Product House of the
Structured Product House of the Year 2006 & 2007
Year 2008
Dec 2008
Contents

Section 1 Basic Facts on inflation 03

Section 2 Structure of Inflation-Linked Bonds 11
Section 3 Inflation Derivatives 32
Section 4 Stripping the inflation curve 44
Section 5 Beta 57
Section 6 Carry 66

2
1 – Basics on inflation

3
Basics on inflation

The Consumer Price Index, in the UK the Retail Price Index, measures the nominal cost of a
representative basket of consumer goods in the economy. In the Euro area, one refers to the Harmonised
Consumer Price Index (HICP). In United States, one refers to the US CPI Urban Consumers NSA (US
CPI).
Nominal price of basket today Index Nominal price of basket at time T Index T
0

The change of purchasing power is measured by the increase in the index Index T
Index 0

However, in the “real” economy the price of the basket (which consists of real goods & services) remains
constant, say $100 (these are “real $”)
Real Economy Nominal Economy
time 0: $100 $100
Index T
time T: $100 $100 x
Index 0

Index t
Inflation is the rate of change of the index, usually measured annually: Inflation t = −1
Index t −1
and so Index T = Index 0 ⋅ (1 + Inflation1 ) ⋅ (1 + Inflation 2 ) ⋅ ... ⋅ (1 + Inflation T )

4
Definitions

Nominal Yield: Yield of a nominal bond or fixed-rate bond (Treasury, Gilt, OAT...)

Real Yield: Yield of an inflation-linked bond (TIPS, Indexed Gilt, OATi, OATei...)

Inflation Breakeven (or IBE): Forward inflation implied by the level of real and nominal
yields
(1+Nominal Yield) = (1+Real Yield) * (1+ Inflation Breakeven Yield )
The Fisher Equation
Most of the time, the market looks at the spread, i.e. the first approximation:
IBE ~ Nominal Yield - Real Yield
The inflation breakeven is the level of future inflation required to obtain similar returns between
an investment in linkers and an investment in nominal bonds over the holding period.

In theory, a risk premium is attached (the premium an investor is ready to pay in order to offset
the risk on future inflation). There is no clear consensus about the value/behaviour of the risk
premium.

5
The global inflation market at a glance
A relatively new asset class with USD 1 700bn market cap in June 2008

„ All G7 countries have now issued inflation-linked bonds, with Germany the latest to join in March 2006.
„ US, UK and Euro-denominated are the three biggest inflation government bond market in terms of
market cap, with Euro superseding the UK market as second biggest market in terms of notional.
Japanese inflation market is still relatively small.
„ Euro and US are the fastest growing and most liquid inflation bond markets.
„ Europe has the largest and most liquid inflation derivative market, followed by the UK, whereas the US
inflation derivative market is still in its early stages.
„ The Euro Inflation market has the broadest product range (sovereign issuers, government bonds,
agency bonds, MTNs, swaps, options and exotics) and largest number of indices.
„ The Emerging market’s size is USD 230bn, mainly Latam with only South Korea in Asia.

6
 A worldwide market
Europe
Americas Asia
„ Total: ~USD 780 bn
„ Total: ~USD 762 bn „ Total: ~USD 96 bn
„ France: USD 235 bn
„ United States: USD 518 bn „ Japan: USD 84 bn
„ Italy: USD 119 bn
„ Canada: USD 41 bn „ South Korea: USD 3 bn
„ Germany: USD 30bn
„ LatAm: USD 203bn „ Australia: USD 9 bn
„ Greece: USD 25 bn
„ United Kingdom: USD 329 bn
„ Sweden: USD 40 bn

Market Cap

USD bn Jun-08 Market Cap

USD bn Jun-08
US 518.0 36.2%
UK 328.9 23.0% Brazil 149.1 64.6%
France 235.4 16.4% Argentina 16.5 7.2%
Italy 119.2 8.3% Chile 6.3 2.7%
Sweden 39.8 2.8% Colombia 8.1 3.5%
Canada 41.2 2.9% Mexico 23.2 10.0%
Japan 84.3 5.9% Poland 5.4 2.4%
Greece 25.1 1.8% Turkey 7.3 3.2%
Germany 29.8 2.1% S. Africa 12.3 5.3%
Australia 9.1 0.6% South Korea 2.7 1.2%
Total 1,431 Total 231
Dur 9.5 Dur 6.0

UK first issued Canada US issued France issued Italy & Greece Japan issued Germany issued S. Korea issued
IL Gilts issued RRB TIPS the first OATi issued the first the first JGBi the first BUND€i the first KTBi
and OAT€i BTP€i & GGB€I

1981 1994 1997 1998 & 2001

1997 2003 1998 & 20012004 2006
2003 2007

7
The active OECD markets

% Indexed
Indexed % Indexed % Total Expected % Total
Update: Jul No Notional Notional Average Debt Issued 2007
(Local bn)
Nominal Debt Issued Issues 2008 Issues
08 Lines (EUR bn) Duration (Indexed (EUR bn)
(EUR bn) (Notional) 2007 (EUR bn) 2008
Notional)

France 12 133 133 148 7.4 15% 17% 18 16% 20.0 16%

Italy 8 87 87 95 7.0 8.0% 8.6% 15 8% 20.0 11%

Germany 2 20 20 21 7.3 2% 2% 6 4% 11.0 7%

Greece 2 15 15 16 15.0 6% 7% 4 10% 4.0 10%

Total EMU 24 254 254 280 7.7 8% 8.9% 42 7% 55.0 9%

US 25 436 275 319 7.3 12% 15% 47 10% 41.0 9%

UK 14 90 113 196 12.9 22% 33% 21 20% 20.1 23%

Japan 16 9502 56 50 8.7 1% 1% 19 2% 17.7 2.4%

Sweden 6 218 23 27 8.7 23% 26% 0.8 10% 0.3 5%

Canada 5 24 15 16 15.9 9% 9% 1.5 6% 1.3 6%

TOTAL 90 736 889 8.9 7% 8.9% 132 6% 135 8%

8
Liquidity across primary markets in the US, Europe and UK

Outstanding Inflation-linked Debt in Nominal Terms (USD bn)

500 O u tsta n d i n g I n fl a ti o n -l i n k e d D e b t (U S D , b n )

400 T IP S

300 EUR+ FRF

200

100 GBP

0
J a n -0 0 J a n -0 2 J a n -0 4 J a n -0 6 J a n -0 8

Outstanding Inflation-Linked Debt Market Capitalisation (USD bn)

600 Sum
I L B o n d s M a r k e t C a p i ta l i sa ti o n (U S D , b n ) (R H S ) 1200
500

400 900

300
UK 600
200 U S T IP S
300
100
EUR+ FRF
0 0
J a n -0 0 J a n -0 2 J a n -0 4 J a n -0 6 J a n -0 8

Source: ICAP and BNP Paribas estimates for Total 9

 Outstanding inflation-linked bonds

EUR bn
US EMU UK SWE JPY
60
Over the years, the government issuers
50
have increased the issuance of inflation-
linked bond to create a real curve, with 40
inflation-linked bonds across all 30
maturities. 20

10
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2008
YTD For.

US TIPS UK inflation-linked Gilts EUR inflation-linked bonds

USD GBP bn EUR bn Bundei-16
30 Outstanding Amount Indexed Amount
Outstandings 20
25
25 Notional Amounts
15 Old 20
20 OATi BTPei OATei
GGBei
15 15
10
10 10

5 New
5
5

0
0 0
2008 2012 2016 2020 2024 2028 2032
2006 2011 2016 2021 2026 2031 2036 2041 2046 2051 2056 2007 2011 2015 2019 2023 2027 2031 2035 2039

10
2 – Structure of inflation-linked bonds

11
Structure of inflation-linked bonds

Index-Linked (or “inflation-linked”) Bonds aim at preserving the purchasing power of the
bondholder,
i.e. compensate for inflation experienced over the life of the bond

To preserve the value of $100 notional, this notional is linked to the inflation index

Indext
i.e. the nominal notional for a payment of the bond at time t is $100 x
where Index0 is the level of the inflation index on issue date Index0

all coupons are paid on this indexed-notional and the indexed notional is repaid at maturity:
e.g. an Index-linked Bond with a 1.5% coupon pays

at coupon date t at maturity T

Indext IndexT
1.5% x 100% x
Index0 Index0

12
Cash Flows of inflation-linked bonds

Comparing the cash-flows of a conventional nominal bond vs. index-linked bond (assuming 2% annual inflation)

Nominal Bond (10y maturity, 3.75% coupon) Real Bond (10y maturity, 1.75% coupon)

Notional (LHS) Notional (LHS)

130 8 130 8
Notional Redemption (LHS) Notional Redemption (LHS)
120
110
Coupon (RHS) 120
110
Coupon (RHS) The cash-flows of
6 6
100 100 an inflation-linked
90
4
90
4 bonds will increase
80 80
70 70 over time
60 2 2
60
50 50
40 0 40 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Nominal Bond (10y maturity, 3.75% coupon) Real Bond (10y maturity, 1.75% coupon)

130 Notional (LHS) 8 130 Notional (LHS) 8

120 Notional Redemption (LHS) 120 Notional Redemption (LHS)
Coupon (RHS)
110 6 110 Coupon (RHS)
6
100 100
90 90
4 4
80 80
70 70
60 2 2
60
50 50 in order to
40 0 40 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 preserve the
purchasing power
Purchasing power of both bonds of the bond holder.

13
Comparison between markets

EMU France US JPY UK new UK old

CPI Urban
Ex-tobacco HICP Ex-tobacco CPI Ex Fresh Food CPI RPI All Items RPI All Items
CPI Index Consumers
unrevised NSA unrevised NSA unrevised NSA unrevised NSA unrevised NSA unrevised NSA
Source Eurostat INSEE BLS MPM ONS ONS
Bloomberg CPTFEMU <Index> FRCPXTOB <Index> CPURNSA <Index> JCPNGENF <Index> UKRPI <Index> UKRPI <Index>

Principal Indexation of principal at maturity

Redemption Minimum redemption at par No guarantee
Coupon Fixed Real Coupon paid on an indexed pricinpal
Fixing In arrears In advance
Lag 3-months 8-months
Frequency Annual Semi-annual
Reference Daily Monthly
Taxation Real rate + inflation Real rate only Real rate only

UK has changed to 3-month lag in arrears with a daily index for new issues since Sep 2005 (UK new)

14
 Comparing UK Gilt IL, Euro €I and TIPS

„ Old UK IL (issued up to Sep 2005) still offer a „ TIPS, Euro(€)is and new UK Gilts use a post-
predetermined semi-annual coupon: determined coupon.
„ Quotes are in £ vs. % for TIPS and euro linkers „ Pre-determined coupon becomes a fixed
„ Coupon is fixed at the beginning of the period, to rate sensitive to inflation
which a 2-month technical lag should be added. „ It reduces the delay between index used and
A total of 8-month delay then is the rule. coupon payment
„ Accrued interests are calculated in reference to
a known coupon.
„ Advantages of post-determined coupon:
„ The reference index is the RPI, Retail Price
„ It reduces the delay which remains constant
Index, including mortgages. That creates a
(3 months) regardless of coupon frequency
mechanical link between nominal rates and RPI.
„ An easy method to calculate accrued
interest

15
 Ca

0
5
10
15
20
25
de
B T s i-0 6
Pe
O A i- 0 8
T

Real
O A i- 09

Nominal
C a T i- 1
de 1
O A s i-1
Te 1
O A i-1 2
C a T i- 1
de 3
B T s i-1 3
Pe
Duration

C N i- 1 4
A
O A i-1 6
Te
R F i-2
F 0
G G e i- 2
Be 3
O A i- 2 5
T
O A i- 29
Te
B T i-3 2
Pe
i- 3
5

Ca
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0

de
B T s i-0
Pe 6
O A i- 0 8
T
Real

O A i - 09
Nominal

C a T i- 1
Characteristics of inflation-linked bonds

de 1
O A s i-1
Te 1
⇒ higher duration and convexity than for equivalent nominal bonds

O A i-1 2
C a T i- 1
Inflation-Linked Bonds have lower coupon and higher redemption payment

de 3
B T s i-1
Pe 3
C N i- 1 4
Convexity

O A A i-1
T 6
R F e i-2
F 0
G G e i- 2
Be 3
O A i- 2 5
O A T i- 2
T 9
B T e i-3
Pe 2
i- 3
5
16
Characteristics of inflation-linked bonds

• Modified Duration:

1 ∂(P ⋅ IR) 1 ∂P
• DV01: MDurReal = ⋅ = ⋅
IR ⋅ P ∂Y P ∂Y

∂P DRIt
DV01 = IR ⋅ P ⋅ MDurReal = IR ⋅ IR = IndexRatio =
∂Y DRI0
• Convexity:

1 ∂ 2 (P ⋅ IR) 1 ∂ 2P
Conv Real = ⋅ = ⋅ 2
IR ⋅ P ∂Y 2 P ∂Y

The DV01 is affected by the index ratio,

unlike the modified duration and convexity
over short periods of time
17
Specifics of inflation-linked bonds

Linker Structure: CPI and DRI

CPI is published every month. As there is a delay between the month and the publication of the figure
(usually published towards the end of the following month), this CPI figure cannot be used directly for the
indexation of the bond. An indexation lag is then needed (8 months for old index-linked gilts, 3 months for all
other bonds such as OATi, TIPS and new UK Gilts).

Accrued interest of an inflation-linked bond should not only take into account the value of the coupon but
also the accrued inflation since the last payment date. Apart from the old UK index-linked Gilts, the coupon
paid on all index-linked bonds is only known 3 months prior to coupon payment date.

In order to calculate accrued interest on inflation with precision, one has developed a daily reference index.

18
Calculation of a Daily Reference Index

DRI - Daily Reference Index - is a daily figure calculated as a linear interpolation between the published CPI
with a 2-month and a 3-month lag.
DRI (01-Apr-06) = CPI (Jan-06) = 100.62 DRI (01-May-06) = CPI (Feb-06) = 100.91
DRI (15-Apr-06) = linear interpolation between the 2 CPI figures

dd − 1
DRIddmmyy = CPIm−3 + ⋅ (CPIm−2 − CPIm−3 )
NDm

100.91
100.85200
Publication 100.80367
16-Mar 100.75533
100.70700
100.65867
Publication
100.62
28-Feb 5 10 15 20 25

01-Jan- 01-Feb- 01-Mar- 01-Apr- 01-May

CPI Jan
100.62
CPI Feb
100.91

19
 Settlement of Index-Linked Bonds

Trading Index-Linked Bonds – all other inflation-linked bonds

OATi, TIPS and new Index-linked Gilts are quoted on a real basis, i.e. the price on screen is the real clean price
The real yield of the bond can be calculated from the quoted price in the same way as for a nominal bond,
e.g. UKTI 1 ¼ % Nov-17 trading at 98.40% has a real yield of 1.395 %
T
Ci 100
Dirty = ∑ +
i=1 (1 + Rr ) (1 + Rr )T
i

To calculate the settlement cash amount, the real clean price and the accrued interest have to be adjusted
R.eferenceCPI t
by the IndexRatio =
BaseCPI0
where Reference CPI t is the Daily Reference Index for the settlement date
and Base CPI is the Base Index for the bond
(usually the Reference Index for the first accrual date)

Settlement Price = Adjusted Clean Price + Adjusted Accrued Interest

DRI t n DRI t
Adjusted Clean Price = CleanPrice × Adjusted Accrued Interest = Coupon × ×
DRI 0 N DRI 0

20
Example of calculation of a settlement price

Example with OAT€i 20

Coupon 2.25 % annual on a notional indexed on CPI

DRI Maturity
Redemption 100% ×
DRI 0
Maturity 25 Jul 2020
Price : 108.00 (= Real Clean Price)

Settlement Date: 5 April 2006 Reference CPI 5 April 2006 = 100.65867

DRIt
Base CPI = 96.08560 Index Ratio =
DRI0
Index Ratio: 1.04759 (rounded to the 5 decimal places)
Accrued Interest: 254 days : 2.25% x 254 / 365 = 1.565753%
Adjusted Accrued: 1.565753% x 1.04759 = 1.640268 %
Adjusted Clean: 108.00 % x 1.04759 = 113.139720 %
Adjusted Dirty: 113.139720 % + 1.640268 % = 114.779988 %

21
 Calculation of a settlement price

OAT€i 20 using YA on Bloomberg

Ref CPI
5 April 06

Real DRI 05 Apr 06

Clean rounded to
BaseDRI
Price 5 decimal
places
Adjusted Clean
Price = Real Clean
Price
x Index Ratio

Adjusted Accrued:

Settlement Price =
Adjusted Accrued +
Adjusted Clean

22
Calculation of a settlement price

OAT€i 20 using SXT BXT on Bloomberg

Index
Ratio

Adjusted Clean

Adjusted
Accrued

Adjusted
23
Dirty
Daily Reference Index & Index Ratio

DRI for EUR and FRF inflation are both published on Reuters:
French Eurozone
(OATi, CADESi, CNAi) OAT€i, BTP€I, GGB€I, RFF€i
DRI OATINFLATION01 OATEINDEXED01
Index Ratio OATINFLATION02 -03-04 OATEINDEXED02-03

Reference Index for TIPS and UK Gilts are published for reference only and need to be calculated

24
BNP Paribas Live inflation pages

Bloomberg:
BPIN<GO>

„ Real time bond prices

for EUR, FRF, TIPS,
JGBi and UKTI.
„ Indicative swap levels
for EUR, FRF, UK, ITL,
SP zero coupon swaps
„ Indicative ASW for
EUR & FRF linkers
„ Link to electronic
trading for Eurozone
bonds

Reuters:
BNPPINFLATION
BNPPINFLATION2

25
 BPIN1 Live inflation pages for Europe

Market move:
Nominal levels,
- on a daily (D) or weekly basis (W) for comparison
usual market - of breakeven inflation (BE) purposes
price and yield
Reuters: BNPPINFLATION or real yields (RY)
BNPPINFLATION2
Bloomberg: BPIN1<GO>

First & Second Pages:

„ real time price / yield quotes
„ breakeven inflation (vs reference
bond)
„ nominal yield of reference bond
„ daily and weekly moves of real
rates and breakeven inflation

26
BPIN3 Live inflation pages for US TIPS

Real Yields with Breakeven inflation yields

Links with Bloomberg market prices Daily and Weekly with Daily and Weekly
functions changes Changes

27
BPIN4 Live inflation pages for JGBi

Bond prices
Outstanding JGBi and daily change Real, Nominal and Breakeven inflation yields

Repo rates

28
BPIN5 Live inflation pages for UK index-linked Gilts

Bond prices
Real price for Real Yields with Breakeven inflation yields
Index-linked Gilts new index Gilts Daily changes with Daily Changes

29
BPIN6 & BPIN7 Inflation Swap pages for Europe

30
BPIN Inflation ASSET SWAP pages for Europe

31
3 – Inflation derivatives

32
Derivatives have improved the liquidity of ILB

„ In EUR, the development of the bond market has been driven by derivatives and by the interaction of
derivatives and bonds. In the UK, the launch of the UK Gilt 1 ¼% 2055 has triggered massive interest for
inflation derivatives.
„ In EUR, the initial incompleteness of inflation markets had to be completed by dealers through the use
and adaptation of existing models to the inflation world (CPI / Real / Nominal or Nominal / Inflation)
„ Anomalies have disappeared as the market becomes mature, as it has been the case for the 5y area
and EMU/FRF spreads
„ Inflation cash is more and more traded by derivatives traders, as implemented by BNP Paribas

„ Similarly to nominal derivatives, inflation derivatives offer

„ Balance sheet and accounting alternatives
„ A wide possibility of transactions
„ Tailor-made solutions
„ Appropriate timing and critical size

33
 Additional advantages of derivatives

„ Derivatives breed liquidity where there are no linkers, eg. ITL, ESP inflation markets

„ Derivative prices give indication and opportunities for the future issuance of inflation-linked bonds

„ Relative value tools for the linkers

„ Offer a different way to play strategies

„ Allow to correct local imbalance of the flows (cf. EUR FRF spread)

„ Risk premia (or discount), relative value opportunities

34
Bond holding vs. swap

Inflation-linked bond:
Investment with an initial cash-flow

Inflation exposure through indexation.

Rationale for a swap

Issuer Investor
Some dealers are interested by the inflation X% * Inflation
exposure but not by the balance sheet position
resulting from this acquisition
At maturity:
100% * Max (Inflation, 1)
Some investors, such as asset managers, can
be attracted by the cheapness of the linkers but
not by the inflation exposure

35
Inflation asset swap

Inflation-linked bonds can also be asset-swapped to allow investors to buy a bond without keeping the inflation exposure.
Any cash flow out of the bond (including the balloon inflation payment at redemption) is passed on to the swap
counterparty. In return, the investor receives a money market rate (or a fixed rate) on his investment.

6m Euribor
BNP
Investor Issuer
Paribas
X% * Inflation X% * Inflation

At maturity: At maturity:
100% * (Inflation - 1) 100% * (Inflation - 1)

Asset swap is a relative value tool

The asset swap is the natural link between the (inflation) bond world and the (inflation) swap.
Imbalance on the derivative market lead dealers to paying inflation through their derivatives activity. Their natural hedge is
to buy linkers to cover their inflation exposure. Later, dealers will reduce their balance sheet exposure by offering the
paper in asset swap form thus keeping the inflation hedge

36
Inflation-linked bonds are still cheap versus swap
Real asset swaps are more attractive than nominal one (swap BE are higher than bonds BE), so that
dealers account for balance sheet exposure, maturity and coupon mismatch.
Shorting BEI via swap is then more attractive than via bonds.
03-Dec-08
TIPS Maturity Yield ASW R OIS/Swap ASW/OIS
TIIJAN09 15-Jan-09 16.182 (113.1) 188.1 75.0
TIIJAN10 15-Jan-10 6.481 (11.4) 132.0 120.6
TIIAPR10 15-Apr-10 6.425 (5.0) 122.1 117.0
TIIJAN11 15-Jan-11 5.231 (1.9) 98.6 96.6
TIIAPR11 15-Apr-11 4.778 (8.0) 92.7 84.6
TIIJAN12 15-Jan-12 4.232 74.9 79.6 154.5
TIIAPR12 15-Apr-12 3.050 (12.0) 76.0 64.0
TIIJUL12 15-Jul-12 3.922 93.4 72.7 166.2
TIIAPR13 15-Apr-13 1.724 0.5 64.4 64.9
TIIJUL13 15-Jul-13 3.719 78.0 62.0 140.0
TIIJAN14 15-Jan-14 3.750 87.5 58.0 145.5
Asset Swap
TIIJUL14 15-Jul-14 3.757 108.0 54.6 162.6
TIIJAN15 15-Jan-15 3.537 108.1 51.8 159.9 Discounts
TIIJUL15 15-Jul-15 3.465 124.9 49.5 174.3
TIIJAN16 15-Jan-16 3.307 120.0 47.4 167.4
TIIJUL16 15-Jul-16 3.287 133.0 45.7 178.7
TIIJAN17 15-Jan-17 3.133 128.7 44.1 172.8
TIIJUL17 15-Jul-17 2.909 116.9 42.8 159.7
TIIJAN18 15-Jan-18 2.663 106.9 41.6 148.5
TIIJUL18 15-Jul-18 2.264 79.0 40.5 119.5
TIIJAN25 15-Jan-25 2.886 182.9 32.6 215.6
TIIJAN26 15-Jan-26 2.844 185.4 32.0 217.4
TIIJAN27 15-Jan-27 2.737 176.5 31.4 207.8
TIIJAN28 15-Jan-28 2.559 170.0 30.8 200.8
TIIAPR28 15-Apr-28 2.820 163.9 30.7 194.6
TIIAPR29 15-Apr-29 2.822 163.2 30.2 193.4
TIIAPR32 15-Apr-32 2.595 150.0 29.0 179.0 37
Linkers cheap or derivatives expensive?

More buyers but cheap bond: where is the contradiction?

„ There is no contradiction, the cheapness is versus the swap market where buyers are more influent
„ Inflation-linked bonds are still considered as structured bond, requiring more attention, thus all asset
swaps will be done at a discount to equivalent nominal bonds

Why are swap breakevens higher than bond breakevens?

„ Because of imbalance between supply and demand on inflation swap
„ Because of mismatch risks carried by derivatives houses

Which bond market is the most attractive?

„ In EUR, some government bonds are cheap on an asset swap basis or comparative to the nominal curve.
„ Some TIPS are 50 to 100bp cheaper than nominal
„ No indexed Gilt because of the structural imbalance of the market

Why are tips level and inflation swap dislocated?

„ Dealer position: investors usually buy inflation with floor protection, leaving dealers short vol at zero to
negative strikes.
„ Gamma hedging activities: as ZC swap moves to negative regime, all the floors cross the strikes.
Gamma approaches its peak when getting close to the money. Dealers would be forced to hedge the
change in delta and thus push the underlying to more extreme levels. Ex: 1y ZC swap can move 300bp
in just a few days

38
 Alternative derivatives to offset negative carry

Index-linked bonds have a specific cash-flow format that might suit issuers and some investors but doesn’t
offer the proper carry profile for retail investors.
Eg. With OATi-13 = 1.62% OAT-13 = 3.71% BE = 2.09%
Payment Payment Payment Coupon Redemption
CPI Coupon Redemption Coupon Redemption
date date Date deficit gain
25-Jul-07 102.09 1.65% 25-Jul-07 3.71% 25-Jul-07 -2.06%
25-Jul-08 104.22 1.69% 25-Jul-08 3.71% 25-Jul-08 -2.02%
25-Jul-09 106.40 1.72% 25-Jul-09 3.71% 25-Jul-09 -1.99%
25-Jul-10 108.63 1.76% 25-Jul-10 3.71% 25-Jul-10 -1.95%
25-Jul-11 110.90 1.80% 25-Jul-11 3.71% 25-Jul-11 -1.91%
25-Jul-12 113.21 1.83% 25-Jul-12 3.71% 25-Jul-12 -1.88%
25-Jul-13 115.58 1.87% 115.58% 25-Jul-13 3.71% 100% 25-Jul-13 -1.84% 15.58%

6% 6%
Real coupon 120% Nominal coupon 120%
5% 5% Notional redemption
Notional redemption 100% 100%
4% 4%
80% 80%
1.95% deficit on
3% 3%
60% 60% the cashflows
2% 40% 2% 40%
15% gain on the
1% 20% 1% 20% redemption
0% 0% 0% 0%
1 2 3 4 5 6 7 1 2 3 4 5 6 7

Real coupon Nominal coupon

39
 Cash-flow match, no more negative carry

Instead of paying the sum of the annual inflation at the end......annual inflation is paid every year
No more cash-flow carry mismatch
Eg. With OATi-13 = 1.62% OAT-13 = 3.71% BE = 2.09%

Payment Payment Payment Coupon Redemption

Coupon Inflation Redemption Coupon Redemption
date date Date deficit gain
25-Jul-07 1.62% 2.09% 25-Jul-07 3.71% 25-Jul-07 0.00%
25-Jul-08 1.62% 2.09% 25-Jul-08 3.71% 25-Jul-08 0.00%
25-Jul-09 1.62% 2.09% 25-Jul-09 3.71% 25-Jul-09 0.00%
25-Jul-10 1.62% 2.09% 25-Jul-10 3.71% 25-Jul-10 0.00%
25-Jul-11 1.62% 2.09% 25-Jul-11 3.71% 25-Jul-11 0.00%
25-Jul-12 1.62% 2.09% 25-Jul-12 3.71% 25-Jul-12 0.00%
25-Jul-13 1.62% 2.09% 100.00% 25-Jul-13 3.71% 100% 25-Jul-13 0.00% 0.00%

6% Annual inflation (LHS) 120% 6%

Nominal coupon (LHS) 120%
Real coupon (LHS) Notional redemption (RHS)
5% 100% 5%
Notional redemption (RHS) 100%
4% 80% 4%
80%
3% 60% 3%
60%

2% 40% 2%
No more mismatch
40%

Real 1% 20% 1% 20%

coupon
0% 0% 0% 0%
1 2 3 4 5 6 7 1 2 3 4 5 6 7

40
Annual Inflation
 Additive Inflation Swap

Rationale 6m UTIBO
The coupon is linked to annual inflation and Client BNPP
the principal redemption at maturity is 100%.
X% + Inflation
Inflation can be floored at 0% or only coupon can be floored at 0%

Quick Terms: Additive Swap

Coupon or Inflation
Notional USD 10,000,000 floored at 0%
Effective Date [ ] September 2006
Termination Date [ ] September 2016
Market Convention:
BNPP pays 1.70% + Max (Inflation, 0), annual, 30/360 Index published for the
Index(t ) month 3 month (2 month in
Inflation −1
Index(t − 1) the UK and US) before
Index CPI NSA coupon payment date

Index (t) CPI NSA (each June) Index can also be fixed
earlier or before coupon
Client pays 6M UTIBO start date

41
 Zero-coupon inflation swap

Rationale (1 + X%)T
In a Zero Coupon inflation swap, there is only one payment at maturity:
BNPP pays Inflation, payable at maturity
Inflation Index(T ) Client BNPP
−1
Index(0 )
Client pays (1 + X % )
T
− 1, payable at maturity Inflation

Inflation-linked annuity swap

An inflation-linked annuity swap is equivalent to a string of zero coupon swaps, with the fixed rate being
the same for all payment dates. Although the Notional of each cash flow seems small, the inflation
position can be huge since it is replicated for every payment date.

Maturity 50 years Payment Dates Annually

BNPP pays USD 10,000,000 x Inflationt Inflationt Index(t )
−1
Index(0)
Client pays [
USD 10,000,000 x (1 + 3.05% )t − 1 ]

42
Inflation options

Cap and Floor on annual inflation

A company whose costs are indexed on inflation wants to ensure that costs will not exceed a specified
level. It buys a cap on inflation to receive funds if annual inflation exceeds the strike.
I.e.: [ Max ( Index(t ) - 1, 0 ) ] x coverage x notional
Index(t − 12 )

Call and Put on cumulative inflation

A pension fund investing in a fund wants to ensure protection of the notional value in terms of purchasing
power. At maturity, it receives the inflation weighted appreciation of the notional, floored at zero.
I.e.: Max ( Index(T ) - 1, 0 ) x notional
Index(0 )

43
4 – Stripping the Inflation Curve

44
Choice of Stripping

ƒ How to create an inflation curve

ƒ Instruments for Stripping: Discount Curve, TIPS, TIPS Asset Swap, ZC Inflation Swap

ƒ Choice of Discount Curve

ƒ Nominal Swap, OIS, etc

ƒ Given Discount Curve, choice to strip CPI

ƒ Strip CPI through TIPS (real yield), TIPS Asset Swap
ƒ Strip CPI through ZC Inflation Swap directly

ƒ Seasonality Impact on Stripping

ƒ Inflation Seasonality
ƒ Impact of shock on seasonality

45
How to create an inflation curve?

Main points not to be missed (independent of model used)

The bonds liquidity

The asset swaps link between cash and discount curve
The starting point(s) shortest bond is often too far
The forwards common sense should prevail
The seasonality to reproduce the CPI pattern

BE Swaps
(or Real)
Spot inflation

1y point Asset swap

Bonds

Maturity
46
Need to look at short and long term determinants

„ Long-term determinants „ Short-term determinants

„ Economic activity „Inflation carry

„ Inflation forecasts „Rich Cheap Analysis

„ Market direction and beta „Demand and Supply

„ Demand and supply

47
Asset swap

5.00
4.50
Nom. asw
4.00
Nom. swap
3.50
BE swap BE bond
3.00
Nom. bond
2.50 -Real asw

2.00
1.50 Real bond

1.00
0.50 Real swap
0.00
0y 5y 10y 15y 20y 25y 30y

48
Choice of Discount Curves
TIPS Maturity OIS OIS DF Swap+spread Swap+Spd DF
TIIJAN09 15-Jan-09 0.3729 0.9996 1.4661 0.9983
TIIJAN10 15-Jan-10 0.5823 0.9935 1.8383 0.9798
TIIAPR10 15-Apr-10 0.6677 0.9909 1.8454 0.9754
TIIJAN11 15-Jan-11 1.0051 0.9789 1.9507 0.9599
TIIAPR11 15-Apr-11 1.1014 0.9742 1.9523 0.9553
TIIJAN12 15-Jan-12 1.3871 0.9575 2.9521 0.9133
TIIAPR12 15-Apr-12 1.4746 0.9513 2.1181 0.9319
TIIJUL12 15-Jul-12 1.5607 0.9447 3.1830 0.8929
TIIAPR13 15-Apr-13 1.7956 0.9238 2.4470 0.8998
TIIJUL13 15-Jul-13 1.8663 0.9166 3.0885 0.8690
TIIJAN14 15-Jan-14 1.9938 0.9019 3.2359 0.8495
TIIJUL14 15-Jul-14 2.0989 0.8873 3.4890 0.8248
TIIJAN15 15-Jan-15 2.1922 0.8727 3.6047 0.8051
TIIJUL15 15-Jul-15 2.2669 0.8586 3.8349 0.7796
TIIJAN16 15-Jan-16 2.3334 0.8446 3.8295 0.7652
TIIJUL16 15-Jul-16 2.3872 0.8311 4.0100 0.7411
TIIJAN17 15-Jan-17 2.4349 0.8178 4.0242 0.7258
TIIJUL17 15-Jul-17 2.4717 0.8050 3.9437 0.7165
TIIJAN18 15-Jan-18 2.5047 0.7925 3.8714 0.7071
TIIJUL18 15-Jul-18 2.5300 0.7805 3.6160 0.7106
TIIJAN25 15-Jan-25 2.6187 0.6522 4.6039 0.4839
TIIJAN26 15-Jan-26 2.6130 0.6363 4.6417 0.4597
TIIJAN27 15-Jan-27 2.6063 0.6209 4.5431 0.4469
TIIJAN28 15-Jan-28 2.5998 0.6060 4.4687 0.4333
TIIAPR28 15-Apr-28 2.5981 0.6024 4.4255 0.4321
TIIAPR29 15-Apr-29 2.5925 0.5879 4.4206 0.4142
TIIAPR32 15-Apr-32 2.5819 0.5460 4.3130 0.3726

49
 Strip FWD CPI from TIPS, TIPS Asset Swap, Nominal Swap
Years Date ZC R N
0 5-Dec-08
„ TIPS, ASW, Nominal, Discount Curves 1 5-Dec-09 -4.506% 5.301% 1.912%
2 5-Dec-10 -3.278% 4.155% 1.978%
DRI(sett) ⎡ T ⎤ 3 5-Dec-11 -1.306% 2.471% 2.183%
TIPSDirtyPr ice = ⎢∑
DRI(ref ) ⎣ i=1
c ⋅ DFR (ti ) + DFR (T )⎥ + PVFloor(T ) − PVASW
⎦ 4 5-Dec-12 -0.445% 2.297% 2.406%
5 5-Dec-13 -0.169% 2.211% 2.596%
„ Analogy to Fwd FX 6 5-Dec-14 0.347% 1.859% 2.739%
7 5-Dec-15 0.804% 1.582% 2.839%
⎡ DF (t ) ⎤ E[ DFR (t )] 8 5-Dec-16 1.108% 1.409% 2.907%
FwdDRI (t ) = DRI (0) ⋅ E ⎢ R ⎥ = DRI (0) ⋅ ⋅ convadjR , N 9 5-Dec-17 1.308% 1.297% 2.950%
⎣ DFN (t ) ⎦ E[ DFN (t )]
10 5-Dec-18 1.451% 1.216% 2.974%
⎡ DF (t ) ⎤ E[ DFD (t )] 11 5-Dec-19 1.552% 1.156% 2.986%
FwdFX (t ) = FX (0) ⋅ E ⎢ D ⎥ = FX (0) ⋅ ⋅ convadjD , F
⎣ F ⎦
DF (t ) E [ DFF (t )] 12 5-Dec-20 1.622% 1.113% 2.988%
13 5-Dec-21 1.669% 1.082% 2.982%
14 5-Dec-22 1.696% 1.061% 2.971%
6.000%
15 5-Dec-23 1.710% 1.047% 2.955%
16 5-Dec-24 1.716% 1.036% 2.938%
4.000%
17 5-Dec-25 1.716% 1.029% 2.919%
18 5-Dec-26 1.713% 1.023% 2.900%
2.000% 19 5-Dec-27 1.707% 1.020% 2.883%
20 5-Dec-28 1.700% 1.018% 2.868%
0.000% 21 5-Dec-29 1.693% 1.018% 2.854%
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
22 5-Dec-30 1.687% 1.018% 2.843%
-2.000%
23 5-Dec-31 1.684% 1.017% 2.833%
24 5-Dec-32 1.683% 1.014% 2.825%
25 5-Dec-33 1.683% 1.011% 2.817%
-4.000%
26 5-Dec-34 1.684% 1.006% 2.811%
27 5-Dec-35 1.687% 1.001% 2.804%
-6.000%
28 5-Dec-36 1.690% 0.996% 2.798%
BE R N
29 5-Dec-37 1.694% 0.989% 2.793% 50
30 5-Dec-38 1.699% 0.982% 2.788%
Strip FWD CPI from ZC Inflation Swap

„ Fwd CPI can be stripped directly from ZC Type Tenor Rate Pay Date

Inflation Swap ZCINFL 1Y -3.816% 01Jan10

ZCINFL 2Y -2.758% 01Jan11

ZCINFL 3Y -0.809% 01Jan12

ZCINFL 4Y -0.203% 01Jan13

1
⎡ FwdDRI ( t ) ⎤
t ZCINFL 5Y -0.028% 01Jan14

ZC ( t )≈ ⎢ ⎥ −1 ZCINFL 6Y 0.489% 01Jan15

⎣ DRI ( 0 ) ⎦ ZCINFL 7Y 0.951% 01Jan16

ZCINFL 8Y 1.259% 01Jan17

ZCINFL 9Y 1.464% 01Jan18

ZCINFL 10Y 1.605% 01Jan19

FwdDRI (t ) ≈ DRI (0) ⋅ [1 + ZC (t )] t ZCINFL 12Y 1.763% 01Jan21

ZCINFL 15Y 1.813% 01Jan24

ZCINFL 20Y 1.795% 01Jan29

ZCINFL 25Y 1.801% 01Jan34

ZCINFL 30Y 1.804% 01Jan39

ZCINFL 40Y 1.825% 01Jan49

ZCINFL 50Y 1.434% 01Jan59

ZCINFL 60Y 1.233% 01Jan69

51
Seasonality of inflation

0.40% 0 .4 0 %
E s t im a t e d S e a s o n a l C o m p o n e n t s - F R F E s t im a t e d E C B C o m p o n e n t s - E u ro z o n e
0.30% 0 .3 0 %

0.20% 0 .2 0 %

0.10% 0 .1 0 %

0.00% 0 .0 0 %
Ja n Fe b Mar A pr May Ju n Ju l A ug Sep Oct Nov Dec Ja n Fe b Mar A pr May Ju n Ju l A ug Sep Oct Nov Dec
-0 . 1 0 % -0 . 1 0 %

-0 . 2 0 % -0 . 2 0 %

-0 . 3 0 % -0 . 3 0 %

-0 . 4 0 % -0 . 4 0 %

-0 . 5 0 % -0 . 5 0 %

0 .3 0 % 0 .4 0 %
E s t im a t e d B L S C o m p o n e n t s - U S D E s t im a t e d B O J C o m p o n e n t s - J P Y
0 .2 0 %
0 .2 0 %

0 .1 0 %
0 .0 0 %
Ja n Feb M ar A pr M ay Ju n Ju l A ug S ep Oct Nov Dec
0 .0 0 %
Ja n Feb M ar A pr M ay Ju n Jul A ug S ep O ct Nov Dec -0 . 2 0 %
-0 . 1 0 %

-0 . 4 0 %
-0 . 2 0 %

-0 . 6 0 %
-0 . 3 0 %

-0 . 4 0 % -0 . 8 0 %

52
 Impact of seasonality

There is historical seasonality on the CPI monthly fixings

But how does it impact the stripping ?
If the expected seasonality in future is the same as the one of last year, the impact on inflation
is very limited
120

119

118
Month Seas. Last year 1.70%
1 0.00% 0.00% 117
2 0.00% 0.00%
3 0.00% 0.00%
4 0.10% 0.10% 116
5 0.40% 0.40%
6 0.50% 0.50%
7 0.20% 0.20% 115
8 -0.30% -0.30%
9 0.20% 0.20%
10 0.20% 0.20% 114
11 0.20% 0.20%
12 0.20% 0.20% 1.70%
sum 1.70% 1.70% 113

112

Nov-04

Nov-05

Nov-06
Jan-04

Mar-04

May-04

Sep-04

Jan-05

Mar-05
Jul-04

May-05

Sep-05

Jan-06

Mar-06
Jul-05

May-06

Sep-06
Jul-06
2004 2005 2006

Same pattern on CPI = no seasonality on BE inflation 53

 Impact of seasonality in case of shock

1% shock on July-04 fixing and -1% on Aug-04 fixing (i.e. the July-04 is higher but Aug-04 unchanged)
No impact on 1y inflation Aug-05 /Aug-04
1% impact on 1y inflation Jul-05 /Jul-04

Month Seas. Last year

120.0
1 0.00% 0.00%
2 0.00% 0.00%
3 0.00% 0.00% 119.0
4 0.10% 0.10%
5 0.40% 0.40% 118.0
6 0.50% 0.50%
0.70%
7 0.20% 1.20%
117.0
8 -0.30% -1.30%
9 0.20% 0.20%
10 0.20% 0.20% 116.0
11 0.20% 0.20%
12 0.20% 0.20% 115.0 1%
sum 1.70% 1.70%
114.0

1.70%
113.0

Divergence between past fixings and

112.0
expected seasonality =

Mar-06
Mar-04

Mar-05

May-06

Jul-06

Sep-06

Nov-06
May-04

Jul-04

Sep-04

Nov-04

May-05

Jul-05

Sep-05

Nov-05

Jan-06
Jan-04

Jan-05
seasonality on BE inflation

2004 2005 2006

54
 Transmission of shock in a seasonal pattern

The seasonality impact is a function of the difference between the expected seasonality and the last 12
months’ fixings... AND is a function of the maturity of the inflation swap
A 1% shock on a particular CPI fixing,
will have 1% impact on 1y swap,
0.50% on a 2y swap and
0.10% on a 10y swap...
120.0

Month Seas. Last year 119.0

1.20%
1 0.00% 0.00%
2 0.00% 0.00%
118.0
3 0.00% 0.00%
4 0.10% 0.10%
5 0.40% 0.40% 117.0 0.70%
6 0.50% 0.50%
7 0.20% 1.20% 116.0
8 -0.30% -1.30%
Divergence between 9 0.20% 0.20% 115.0 1%
past fixings and 10 0.20% 0.20%
expected seasonality 11 0.20% 0.20%
12 0.20% 0.20% 114.0 1.70% 1.70%
divided by maturity = sum 1.70% 1.70%
113.0
BE inflation seasonality over time
112.0
Jan-04

Jan-06
Mar-04

May-04

Nov-04

Jan-05
Jul-04

Sep-04

Mar-05

May-05

Jul-05

Sep-05

Nov-05

Mar-06

May-06

Jul-06

Sep-06

Nov-06
2004 2005 2006
55
Seasonality and swap curve

Can one interpolate from any given curve to generate an inflation swap curve ?
The market standard is annual BE zero coupon swaps:
On French inflation: DRI (final) / DRI (Initial) – 1 (base changes every day)
On Euro inflation: CPI (mmm-yy) / CPI (mmm-initial) – 1 (base changes once a month)

122.0
Imagine a EUR flat curve 1.70% on
1y, 3y, 5y August fixing
121.0 1.36%
120.0

Where is the 2y August fixing ? 119.0

1.20%
118.0
And the 2y July fixing ?
117.0

116.0 0.70%
115.0 1% 1.70% 1.70%
From one specific fixing to another one,
the linear interpolation alone is useless...
114.0 1.70%
113.0

… it becomes worse if you are working 112.0

Jan-04

Mar-04

May-04

Jul-04

Sep-04

Nov-04

Jan-05

Mar-05

May-05

Jul-05

Sep-05

Nov-05

Jan-06

Mar-06

May-06

Jul-06

Sep-06

Nov-06

Jan-07

Mar-07

May-07

Jul-07

Sep-07

Nov-07
on non annual inflation

56
5 – Beta

57
 Move of the Market

During a rally, yields are decreasing on both linkers and nominal bonds.
Nominal, real and inflation are correlated. Usually, all three rates are moving in the same direction:

Inflation
Rn R n = R r + Inflation

Rr

A regression shows the relation between 2 rates:

ΔRInflation = 40% ⋅ ΔRNo min al + cst '

Beta= 60%
ΔRReal = 60% ⋅ ΔRNominal + cst
Real Rates

Nominal Rates

One would expect the real rate to decrease less than the nominal rate as the inflation break-even should narrow as
well. As a consequence, when the market rallies, the nominal bonds are usually outperforming the linkers (on a 1-for-
1 hedge ratio).
58
Beta

Linkers are often compared to nominal bonds:

„ Arbitrage
„ Risk management
Even though the relationship is unstable, real and nominal yields are correlated
In order to run portfolios including real and nominal bonds, the concept of beta is widely used

Choice of the Beta

„ Historical Beta or Implied Beta ?
„ Regression on 1m, 3m, 6m, 1y or 5y historic
„ How to distinguish between beta move due to nominal
„ move and out/under-performance ?
„ Beta per (fixed) maturity ?
„ Beta on Levels, changes or total return ?

Not stationary No CPI information

59
Which beta? 5y Generic TIPS Since 2001

Levels, 2001-> May08

3.50

3.00

2.50

2.00
Levels:
1.50

1.00
Beta = 74%
y = 0.74x - 1.09
0.50 R2 = 0.60

0.00
2.0 3.0 4.0 5.0 6.0

Weekly changes, 2001-> May08

0.60

0.40

0.20 1w Changes:
0.00
-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8
Beta = 70%
-0.20

-0.40
y = 0.70x - 0.00
R2 = 0.68
-0.60

60
5y TIPS: Regression in levels shows many regimes

Betas unstable: Depends on:

Levels, 2001-> May08y = 0.71x - 0.32
3.50 Macro and micro factors
R2= 0.85
3.00 Demand & supply
2.50

2.00
y = 0.39x + 0.03
2
1.50 R= 0.54
Feb04 - > 6m ago
1.00
y = 0.9316x - 2.15
0.50 R2= 0.8851

0.00
2.0 3.0 4.0 5.0 6.0
-0.50

61
 What is the beta ? Volatility Ratio * Correlation

3M (annualised) Rolling Volatilities

2.0 2.0
Nom Vol
Beta
1.5 1.5

1.0 1.0
1.0 1.0
Beta (RY,NY)
0.5 0.5
Real Vol 0.8 0.8
BE Vol
0.0 0.0
Sep-01 Sep-03 Sep-05 Sep-07 0.6 0.6
Beta (BE,NY)
0.4 0.4
3m Rolling Correlation and Ratio of Vol
0.2 0.2
Correl (RY,NY)
1.0 1.0
0.0 0.0
0.8 0.8
Sep-01 Sep-03 Sep-05 Sep-07
0.6 0.6

0.4 0.4

Correl (BE,NY)
The beta is the result of both effect (volatility and correlation)
0.2 0.2

0.0 0.0
Sep-01 Sep-03 Sep-05 Sep-07 σ BE
BetaBE = ρ BE , No min al ⋅
σ Re al σ No min al
BetaRe al = ρ Re al , No min al ⋅
σ No min al

62
Where is the risk?

The hedge ratio is the amount of nominal needed to hedge a certain amount of TIPS.
Hedge ratio = DV01TIPS * Index Ratio * Yield Beta / DV01Nominal

Long 100m OAT Nominal

Long 100m OATi Real
Long 100m OATi and Short 100m OAT BE
Long 100m OATi and Short Beta x 100m OAT Beta

In normal situations, the Nominal position is the most volatile.

By construction, the Beta hedge is designed to be market
independent.
The two other trades depend on the Beta :
Beta > 0.5 the Real is moving the most
Beta < 0.5 the BE is moving the most
For short maturities, as the CPI is released on a monthly basis with potential jumps, inflation can move
more than the Nominal (i.e. beta >100%).

63
 Beta: A positive convexity

Real

The beta exhibits a positive convexity. At least in theory. Slope; beta =

d
f (N )
dN
Assuming a 80% beta hedge, the actual beta should be higher in a Gap betw een the
rally and lower in a sell off. beta-hedge

In practice, this has worked only during rally phases.

Gam m a value of
The ILB hedge from the the ILB
duration and beta

dR 1 d 2R 1 d 2R
ΔR ≈ ⋅ ΔN + (ΔN ) 2 ≈ beta ⋅ ΔN + (ΔN ) 2 Relationship betw een real
dN 2 dN 2 2 dN 2
and nom inal yield Nominal

1 5y generic TIPS: The beta rose when yields rallied

ΔILB.Price ≈ ΔR ⋅ Mod .Dur + Cvx ⋅ (ΔR ) 2
2 (1999->2003) but stayed high in spite of the sell off
1 1 d 2R
≈ beta⋅ ΔN ⋅ Mod.Dur + beta2 ⋅ Cvx⋅ (ΔN ) 2 + ⋅ Mod.Dur⋅ (ΔN)2 1.0 2.0
2 2 dN2 Beta (RY,NY)

0.8
3.0
2
1d R
Convexity.Value = 2
⋅ Mod.Dur ⋅ (ΔN ) 2 0.6
4.0
2 dN 0.4

5y Nominal 5.0
0.2
Yield
0.0 6.0
Sep-01 Sep-03 Sep-05 Sep-07

64
Beta Regime Change

„ Simply using historical data for regression would be misleading

„ Even using the complete historical data set will not be sufficient as economic fundamental
continues to evolve

„ Fundamental analysis needed to determine beta regime

65
6 – Carry

66
Carry

„ The level of past, current and future inflation prices is necessary to determine the carry profile of the inflation-linked
bond. Real coupons are usually lower than nominal coupons; this has a negative impact on the carry profile. But the
increase in the inflation ratio may largely offset this loss.

„ Due to the structure of inflation-linked bonds (notional accreting with the index ratio), the nominal notional and therefore
the dirty price of inflation-linked bonds fluctuates with the monthly changes in the CPI (with the appropriate 3-month
lag).

„ Part of the carry profile for linkers is known as soon as the CPI is published (the index ratios for the following calendar
month are fixed). Beyond that, future expectations of CPI evolution will determine the carry and therefore the value of
linkers.

„ FP(T) = GP(0)*(1+repo*T/360) - Accrued(T) for nominal

note
„ FP(T) = GP(o)*CPI(0) /CPI(T)*(1+repo*T/360) -Accrued(T) for TIPS and
OATis
with FP = Forward Price, GP = Gross Price, CPI = CPI index (taking into account the lag)

„ Furthermore, distribution of fwd CPI needed for carry calculation or the carry can be approximated through the
expected fwd CPI values.

67
Carry: simplified example

„ assuming the following market:

„ inflation-linked bond: 1.80% real coupon, duration = 8
„ nominal bond: 4.20% coupon, duration = 7.5
„ both bonds trading at par inflation ⇒ breakeven = 2.40%
„ repo rate for both bonds: 2.10%

1-month carry for nominal bond: (4.20%-2.10%) / 12 = 0.175%,

or 0.17% / 7.5 = 2.3bp

68
Carry: simplified example

„ Scenario 1: DRI: +0.4% m/m

1-month carry for real bond: (1.80%-2.10%) / 12 + 0.4% = -0.025% + 0.4% = 0.375%,
or 0.375% / 8 = 4.7bp
„ Scenario 2: DRI: -0.2% m/m
1-month carry for real bond: (1.80%-2.10%) / 12 - 0.2% = -0.025% - 0.2% = -0.225%,
or -0.225% / 8 = -2.8bp
„ Breakeven carry:
„ Scenario 1: 4.7bp - 2.3bp = 2.4bp
„ Scenario 2: -2.75bp - 2.3bp = -5.1bp

to have flat breakeven carry, we need the DRI increase to be equal to 0.175% +
0.025% = 0.2%,
which is an annualised breakeven of 2.40%

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Real carry more volatile than nominal carry

Rolling 1m carry for the OATi 2009 and OAT 2009

15 OATi 2009
OAT Apr 09
10

-5

-10
Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04

1m carry between Sep 98 and May 2004

This shows that breakeven inflation (to
maturity) is not the only variable to consider.
bp Average Lowest Highest Std Dev.
Short-term, the inflation carry will influence
the market strongly. OATi 09 1.34 -7.8 12.8 3.23
OAT 09 1.33 -1.1 3.7 0.96
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TIPS BE vs USD ZC Swap

Measuring Inflation: TIPS BE and ZC Inflation Swap

TIPS BE vs ZC Inflation Swap TIPS BE

ZC Swap
ZC Swap Start 01 Jan 09
500.0

0.0
10-Oct-06 1-Apr-12 22-Sep-17 15-Mar-23 4-Sep-28 25-Feb-34 18-Aug-39

-500.0
BE/ZC

-1000.0

-1500.0

-2000.0
Maturity

71
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