Pricing inflation linked bonds

Abstract

Inflation always plays an essential role in an economy. Many countries have started introducing inflation-protected securities. The fear of inflation has put hedging inflation risk a top priority in the investment world. In Israel, the inflation-indexed bonds account for over 80% of the total fixed income market! Because of the surge of investors’ demand, inflation-indexed security market has been growing quickly. Inflation-linked securities have been widely accepted by many institutional and individual investors. The Treasury Inflation Protection Securities (TIPS) in the United States were first introduced in January 1997 and expanded quickly. As of October 2004, a total of 16 TIPS have been traded (including one expired TIPS) in the market, and the TIPS market has grown to over $176 billion, or 7% of the total outstanding treasury debt by the end of 2003. The world’s first known inflation-indexed bonds were issued by the Commonwealth of Massachusetts in 1780 during the Revolutionary War, when those bonds were invented to deal with severe wartime inflation and with angry discount among soldiers in the U.S. army with the decline in purchasing power of their pay. While the introduction of the inflationindexed bond issued in 1780 marked a great advance in the financial innovation history, it did not flourish until the twentieth century. During the 1950s and 1960s several countries experiencing hyperinflation – such as Argentina, Brazil and Mexico – issued such securities as a means of maintaining the acceptability of long-term debt contracts. More recently, however, indexed bonds have typically been issued by governments with a different set of motives. Those countries that have embarked on index-linked issuance since the early 1980s have generally been those with a commitment to low inflation already established and so have looked to indexed debt for cost savings and to enhance the credibility of their monetary policies.