Analysis Of Inflation-indexed Bonds

Indexed debts emerged from the eighteenth century. Until mid-1990's, especially after the US Treasury starting to issue inflation indexed securities (IIS) in 1997, indexed debts became an important part of global financial market. Although newly invented, IIS benefits both investors and borrowers substantially. With the development of capital market of China, and particularly China's faster integration into the world after its WTO entry, it is necessary for us to improve knowledge of this new financial instrument in the global market. Besides conclusion the paper consists of six parts to fill this need.Part I (Review) starts from clarifying the characteristic of IIS by reviewing the history. The basic fuction of IIS is to provide fixed real return to investors, which protects their investments from the erosion of inflation. Though this protection is not perfect due to the selection of the index, delay of the index, and taxation effects, IIS still has irreplaceable advantages to other finacial instruments. The primary objective of this part is to summarize IIS's basic information before further in-depth analysis.Part II (Functions of IIS) takes the perspective of borrowers. Major issuers of IIS are the governments of sovereign states. IIS could lower the cost of borrowing for the government and help to maintain the stability of capital market in long term. The government could use IIS to reduce fiscal deficits and curb corresponding risks too. Monetary policy-makers could find helpful information provided by IIS market, which will be discussed in detail in the last part of the paper.Part III (Design of IIS) scrutinizes factors related to the design of IIS terms. The first step of the design is to select the index. IIS should be able to hedge risks. Different index may hedge different risk. The choice of index becomes vital as investors facing diverse risks. Besides, the index should be trustworthy and complete in term of corresponding risk. The cash flow structure is important in the design of financial instrument. Applying various bond terms, IIS could take different formats such as CIB, IIB, CPB, LAB, and IZCB. IIS is pegging to the index. The delay of the index will effect the value of IIS. Howerer, delay is unavoidable the time consumed in data collection and distribution for index and trading clearance routines. Taxation decreases certainty of IIS after-tax return as well. This factor should be take into account during the design also. In practice, options are there for issue. Costs and sizes of IIS are consideration fo the selection of issue procedure, which could be Dutch auction, American (English) auction, or in tap form.Part IV (Feasibility of IIS in China) and PART V (Experiments of IIS in China) both deal with China particular contents. Part IV focuses on those concrete conditions, of which some aregood for IIS issue while others are not. In short, currently China has formal ways to compile and release price indices. But the bond market will take time to be matured. The State Government should be the major IIS issuer. Consumer price index should be the best choice. Issuing will take different forms as investors vary. IIS could bring new problems to current tax policies, which need to be answered. Security surveillance will encounter new challenges, as IIS is different from ordinary bonds. Based on history of indexed debts in China, Part V analyzes current necessity and possibility of promoting IIS .The sixth issue of treasury bond in 1996 is used as an example to show how IIS could cut cost of borrowing for the government. Part V also suggests that it is right time to issue IIS now provided there would be no explosive high inflation expectation in the future.Part VI extends the last point in Part II. In this part, data from UK's IIS market are used to estimate inflation expectation and to conduct statistical hypothesis tests to the Fisher equation. The results reveal that information extracted from IIS is important for making monetary polices.The conclusion of the paper is t...