Index Linked Bonds and Inflation Derivatives
In 97 the market for index-linked products has grown enormously in the 2000s where the derivatives market started up and since about 2003 we've had a very active derivatives market in a range of products and swaps being the most illiquid and more recently as it's about o 7 we've had inflation options which are trading fairly liquidly as well now inflation's become of grow great of interest recently in the markets because of course we have two factors which are very much in operating in opposing directions if you think about the credit crunch that's of course an immensely deflationary event in the markets and in response to that governments have an ultra loose monetary policy interest rates have come down to practically zero in an awful lot of economies and we have negative interest rates in some places and we have quantitative easing consequence of that of course is that you have a potential for deflation from the initial driving force the credit crunch and a potential for a lot of inflation from the policies that have been put in place to counter the impact of the credit crunch and the question is which one of those two forces is going to be in the ascendant and that's where our index-linked bonds and perhaps more importantly our derivatives come into play giving fund managers banks pension funds the ability to remove the risk inflation is determined by the overall activity in any given economy it's not something that just is subject to the fluctuations of market supply and demand so when you're trading and inflation-linked product as opposed to an interest rate product then you're trading something with reference to an economic variable which is not affected by the actual process of trading that rate so inflation is a little bit different in that respect to other assets if you like the use of inflation products be they bonds or derivatives it is of course to transfer risk from one party that the group that's long inflation for example for example a government can issue index-linked bonds allowing the people who are very short inflation the people who suffer from inflation to borrow those bonds and thereby hedge their inflation risk derivatives of course provide a much wider range of techniques and solutions to different parties inflation exposures one other example of the use of inflation derivatives in the recent past has been by hedge funds who have been able to buy index-linked bonds which historically have traded quite cheap in relation to the rest of the market in relation to nominal bonds and by buying an index linked bond and doing an asset swap and then doing the reverse transaction with a nominal bond the hedge fund has actually been able to pick up quite a a good return from that structure well that the starting point really is your inflation once you've got that then you can use that to value and revalue a range of inflation derivative so we want to look at zero coupon inflation swaps then we build up an inflation curve based on the swaps market and we can compare that with the inflation curve that we get from index-linked bonds and the difference between the two which actually can be quite significant and it has been for some time in the united states gives rise to possible strategies that we can put in place in the interest rate world we can easily derive a forward interest rate from zero coupon rates in the inflation world that's not quite so easy because of course inflation is only known at the end of a given time period it's not known about at the beginning of that time period which means when you try and derive forward inflation from zero coupon inflation we have to introduce a and adjustment which is derived from the volatility of inflation and actually also the volatility of interest rates so if we're looking at derivatives we tend to build an inflation curve which is derived from derivative products and taking into account seasonality and then use that to revalue and manage the risk of our existing positions when we want to think about options on inflation then of course we need to look at our basic inflation curve and think about the impact of volatility in inflation on the price of inflation options and there are a number of different styles or varieties of inflation options that are starting to become more and more liquid in the market the LFS inflation course shows you how to use derivatives and index-linked bonds to hedge trade and manage risk in today's market exercises and spreadsheets help you apply what you have learnt as your career progresses well in the LFS program we look at a range of things we start off by building up an inflation curve from index-linked bonds so we take index-linked bonds and we produce innovation curve where we have zero coupon inflation which is inflation from a particular point in time to a specific point in time in the future rather than some sort of measure of break-even inflation involving yields this of course is a much more precise measure of inflation that's traded in the markets and it's an essential part really amusing doing anything either in index-linked bonds or with inflation derivatives we then go on to have a look at the swaps market and of course consider one of the big features of the inflation market which we don't have in the market for interest rates products which is a seasonality in inflation the issue with any program which is quite technical and quite in-depth and which involves a lot of some nuts and bolts or how to do it type of information is actually making the transition between the classroom and what goes on in the office and one of the things we do is have a look at index-linked bonds on asset swap so you can take an index linked bond and you can compare it with a nominal bond in terms of an asset swap so you can transform both bonds into a nominal floating rate note and you compare the spread overall under LIBOR that stems from doing an asset swap now of course in order to do that you've actually got a look at the cash flows and you could have work out what the asset swap levels aren't we course do that in one of the exercises then you've got to think a little bit about some of the sort of practicalities around doing an asset swap in other words the the credit risk that you take by asset swapping a high coupon bond versus a low coupon bond doing that that sort of aspect which isn't easy to capture in a spreadsheet has to be thought about as well we have a wide range of pension fund managers we have inflation traders we have middle office people who are in the process of analyzing the models being used for managing inflation risk we've had a lot of interest from central banks and government on government bodies a range of people from a number of different sorts of institutions local banks banks in other parts of Southeast Asia and also fund managers as well based in that region you,
inflation, derivatives, index-linked bonds, lfs, fixed income, hedging, risk management
In 97 the market for index-linked products has grown enormously in the 2000s where the derivatives market started up and since about 2003 we've had a very active derivatives market in a range of products and swaps being the most illiquid and more recently as it's about o 7 we've had inflation options which are trading fairly liquidly as well now inflation's become of grow great of interest recently in the markets because of course we have two factors which are very much in operating in opposing directions if you think about the credit crunch that's of course an immensely deflationary event in the markets and in response to that governments have an ultra loose monetary policy interest rates have come down to practically zero in an awful lot of economies and we have negative interest rates in some places and we have quantitative easing consequence of that of course is that you have a potential for deflation from the initial driving force the credit crunch and a potential for a lot of inflation from the policies that have been put in place to counter the impact of the credit crunch and the question is which one of those two forces is going to be in the ascendant and that's where our index-linked bonds and perhaps more importantly our derivatives come into play giving fund managers banks pension funds the ability to remove the risk inflation is determined by the overall activity in any given economy it's not something that just is subject to the fluctuations of market supply and demand so when you're trading and inflation-linked product as opposed to an interest rate product then you're trading something with reference to an economic variable which is not affected by the actual process of trading that rate so inflation is a little bit different in that respect to other assets if you like the use of inflation products be they bonds or derivatives it is of course to transfer risk from one party that the group that's long inflation for example for example a government can issue index-linked bonds allowing the people who are very short inflation the people who suffer from inflation to borrow those bonds and thereby hedge their inflation risk derivatives of course provide a much wider range of techniques and solutions to different parties inflation exposures one other example of the use of inflation derivatives in the recent past has been by hedge funds who have been able to buy index-linked bonds which historically have traded quite cheap in relation to the rest of the market in relation to nominal bonds and by buying an index linked bond and doing an asset swap and then doing the reverse transaction with a nominal bond the hedge fund has actually been able to pick up quite a a good return from that structure well that the starting point really is your inflation once you've got that then you can use that to value and revalue a range of inflation derivative so we want to look at zero coupon inflation swaps then we build up an inflation curve based on the swaps market and we can compare that with the inflation curve that we get from index-linked bonds and the difference between the two which actually can be quite significant and it has been for some time in the united states gives rise to possible strategies that we can put in place in the interest rate world we can easily derive a forward interest rate from zero coupon rates in the inflation world that's not quite so easy because of course inflation is only known at the end of a given time period it's not known about at the beginning of that time period which means when you try and derive forward inflation from zero coupon inflation we have to introduce a and adjustment which is derived from the volatility of inflation and actually also the volatility of interest rates so if we're looking at derivatives we tend to build an inflation curve which is derived from derivative products and taking into account seasonality and then use that to revalue and manage the risk of our existing positions when we want to think about options on inflation then of course we need to look at our basic inflation curve and think about the impact of volatility in inflation on the price of inflation options and there are a number of different styles or varieties of inflation options that are starting to become more and more liquid in the market the LFS inflation course shows you how to use derivatives and index-linked bonds to hedge trade and manage risk in today's market exercises and spreadsheets help you apply what you have learnt as your career progresses well in the LFS program we look at a range of things we start off by building up an inflation curve from index-linked bonds so we take index-linked bonds and we produce innovation curve where we have zero coupon inflation which is inflation from a particular point in time to a specific point in time in the future rather than some sort of measure of break-even inflation involving yields this of course is a much more precise measure of inflation that's traded in the markets and it's an essential part really amusing doing anything either in index-linked bonds or with inflation derivatives we then go on to have a look at the swaps market and of course consider one of the big features of the inflation market which we don't have in the market for interest rates products which is a seasonality in inflation the issue with any program which is quite technical and quite in-depth and which involves a lot of some nuts and bolts or how to do it type of information is actually making the transition between the classroom and what goes on in the office and one of the things we do is have a look at index-linked bonds on asset swap so you can take an index linked bond and you can compare it with a nominal bond in terms of an asset swap so you can transform both bonds into a nominal floating rate note and you compare the spread overall under LIBOR that stems from doing an asset swap now of course in order to do that you've actually got a look at the cash flows and you could have work out what the asset swap levels aren't we course do that in one of the exercises then you've got to think a little bit about some of the sort of practicalities around doing an asset swap in other words the the credit risk that you take by asset swapping a high coupon bond versus a low coupon bond doing that that sort of aspect which isn't easy to capture in a spreadsheet has to be thought about as well we have a wide range of pension fund managers we have inflation traders we have middle office people who are in the process of analyzing the models being used for managing inflation risk we've had a lot of interest from central banks and government on government bodies a range of people from a number of different sorts of institutions local banks banks in other parts of Southeast Asia and also fund managers as well based in that region you,inflation, derivatives, index-linked bonds, lfs, fixed income, hedging, risk management
