Inflation Investments New Risks and Opportunities

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Inflation InvestmentsNew Risks and Opportunities

• July 2007
• Georges Sitbon
• Head of Inflation and Property Derivatives

Tel [phone] Bloomberg and Reuters
Menu CAID
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Agenda

• Inflation linked products overview
• Fixing inflation dealing with publication lag
• Inflation linked bonds
• Swaps and options market standards
• Structured notes from standards to exotics and
  hybrids
• Understanding and overcoming inflation products
  specific risks
• Marking the market how to build a swap curve
• Marking the market Calyon contribution to
  transparancy
• Seasonality dealing with non financial events
• Credit risk is there a free lunch?
• Unliquidity risk or opportunity?
• Volatility and correlation the new playing area

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Inflation-Linked Products Overview
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Fixing inflation dealing with publication lag
CPI and DIR

• Difference between CPI and DIR

ö
æ
ö
æ
-
1
j
CPI consumer price index DIR daily index
reference

ç

ç
CPI
-
CPI
x


CPI
DIR

ç
-
3
2
m
m

-
-
3
m
j
ç
NBD
ø
è
m
ø
è
Example
104.05 (11/31)(104.31- 104.05)
104.14226
12/07/07

May
104.31
April
104.05
01/07/07
01/06/07
01/05/07
01/04/07
01/08/07
Publication CPI
Publication CPI
April
May
Publication IPC février 23/03/02
Publication IPC mars 23/04/02
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AFT fixing contribution
CPI Reference page
All DIR can be found on the treasury web
sites But you can also get it from Reuter pages
OATEI01 and OATINFLATION01
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How to find DIRs in Bloomberg
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Risks embedded in the CPI release

• Independence of the calculation
• The CPI has to be released by an
  independent/reliable institution
• The CPI calculation methods must be clear and
  transparent
• Rebasing
• Series rebasing must have no impact on past flows
  and forward calculations
• Basket rebasing must be frequent, regular and
  close to reality
• Release delayed
• Can happen in late February
• Confirmations plan substitution by the last fixed
  inflation utill the release
• Index disruption
• Confirmation plan that both counterparties agree
  on a substitution index
• If no agreement on substitution index, both sides
  must agree on the terms of the contract
  termination.

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Inflation Linked Bonds

• A fixed coupon on an inflated principal
  the inflated principal at maturity.

Compounded inflation
100
Cash flows overview
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Inflation swaps
Standard swaps

• Periodical Swap

• Zero Coupon Swap

n number of years to maturity.
NBThere is no calculation basis on the
inflation leg. It is an index performance between
two unadjusted dates.The calculation basis on
the fixed leg is 30/360 on unadjusted dates.DIRs
and CPIs are unrevised first publication of
definitive index
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Inflation options
Caps/Floors

• A) Caps

B) Floors
At each period
At each period
Cap buyer pay-off
Floor buyer pay-off
Strike
Strike
Inflation rate
Premium
Inflation rate
Premium
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Inflation options
Swaptions

• A) Zero Coupon Swaption

B) Periodical Swaption
Right to enter in m years in a zero coupon swap
of (n-m) years maturity of strike K
Right to enter in m years in a periodical swap of
(n-m) years maturity of strike K
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Standard inflation linked structured notes
Additive

Multiplicative
ILB style
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Inflation Hybrids and Exotics

• Interest rate / inflation correlation products
• Inflation boosted coupon min( EuriborX 2
  inflation) or min( GearingCMS 2.5inflation)
  (floored at 0)
• Inflation guaranteed coupon max( CMSX
  1.5inflation) (floored at 0)
• Inflation / inflation correlation products
• Inflation spread boosted coupon 3.50
  Gearing(European inflation French inflation)
  (capped at 7 floored at 0)
• Inflation best of coupon 1.7 best of
  (Italian inflation European inflation)
  (capped and floored)
• Exotic payoffs
• Inflation range accruals quarterly (n/3)(3M
  Euribor X) were n number of times when European
  inflation is inside 1.53 in the three last
  monthly fixings
• Inflation CMS (coming soon) X Gearing
  (Inflation CMS10Y - Inflation CMS2Y)
• Inflation quantos X US inflation paid in
  Euro.

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Inflation Products Specific Risks
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Building inflation linked swap curve

• When ILB market
• Pricing is dynamic
• ILB Asset Swap is the adjusment variable

Govies real yield
ILB Price
Interbank real yield
ILB ASW Price
Interbank Inflation yield
Interbank nominal yield
Market data
Less Iiquid market data
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Calyon real time contribution (Reuters)
Coming soon - AFT linkers strips - Caps an floor
prices
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Calyon real time contribution (Bloomberg)
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European Inflation Linked Bonds
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US TIPS
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Calyon page on ZC swaps (EUR)
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Calyon page on ZC swaps (Others)
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Inflation swap curves
Zero coupon curves
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How to build forward curves

• We know European ex tob APR07 CPI 104.05
• From definition of zero-coupon swap CPIAPR07i
  CPIAPR07 x (1ZCi )i
• Calyon provides ZCi (CAID Menu)
• One can calculate all the APR forward CPIs
• Then one can calculate all APR annual inflation
  forwards

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Taking seasonality into account

• Origins of seasonality - winter and
  summer sales
• - energy, fresh food...
• - taxes (tobacco) and more

• Seasonality factors CPI Linear CPI ( 1
  month factor )

• Products in which seasonality pricing is
  essential Asset swaps, backward start, short
  period, Livret A, etc...
• Once one know all MAR forward CPIs and
  seasonnality parameters, one knows all forward
  CPIs
• Seasonality factors are very volatile and forward
  are based on average rules.
• One will find as many methods and factors as
  banks.
• Seasonality behaviour is a local data.

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Hedging seasonal fixings
Calendar spreads
Futures on Eurpean inflation ex-tobacco

• Very illiquid
• Only on European inflation ex-tob
• Only 12 next CPI

Calendar spreads are the best solution (EU XT
example)
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Inflation linked bond credit specificity
ILB
Buying ILB/ Selling Nominal Bond
Nominal bond
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ILB ASW is there a free lunch?
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Unliquidity risk or opportunity?

• Bid offer spreads reflect
• Existance of ILB or not
• Short term (1Y, 2Y) is less liquid than longer
  term
• 10bp bid/offer on a 1Y ZC swap means 10ct
  bid/offer on next year CPI release while on a 5Y,
  it means around 50ct on the five year forward
  CPI.
• Market is unbalanced due to
• Poor natural offer on the offer side on
  derivatives except project finance and utilities
• All EMTN deals produce a bid interest on the swap
  curve
• Big size on the French inflation swap due to
  Livret A (French saving accounts) indexation on
  inflation
• High forwards on French inflation contaminate
  correlated curves
• The only offer comes on the bond side
• The ILB ASW results much cheaper than the nominal
  one only because of swap expensivness
• Unliquidity provides arbitrage opportunities.

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Macroeconomic historical data
Take profit from liquidity gaps
Example the inflation spread boosted coupon
15Y Maturity 4.80 first 1Y 4.80 10(European
inflation French inflation) (capped
at 7.6 floored at 2)

• The European Inflation French Inflation
  spread value is currently 58 bps (Apr 07) and
  74 bps (May 07).
• Last 10Y historical average 40 bps
• 90 of the last 10Y historical fixings are more
  than 10 bps.

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Economists expectations

• All european domestic inflations should converge
  to european average
• This european averages includes
• Traditional  countries inflations like France
  and Germany
•  border  and new entrants inflations
• The first category is structurally lower than
  the second.
• To stay competitive with low production costs at
  new entrants, France wages should not be
  inflationist
• May tax harmonisation occur, taxes are higher in
  France than average.
• French Social VAT hike, if occur, would come
  with deflationist measure to keep purchasing
  power stable

• Rather than narrowing the spread between French
  and European inflations should widden

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Market forwards compared to expectations

• French saving accounts are indexed on inflation
• Hedges are 5Y to 15Y maturity
• Size to hedge are much more important than what
  the market can absorb
• Forwards are artificially high because of
  liquidity lag
• From 1Y to 5Y threat of inflationist impact on
  social VAT

Why??
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Volatility and correlations

• The inflation options market stated with additive
  inflation EMTN because the coupon (Xinflation)
  must be positive and can be capped.
• Contrary to nominal market,  far from the
  money  strikes are more liquid than ATM ones.
• Difficulty stands in bulding an ATM volatility
  matrix
• 3 factcors model is commonly used in the market
  as we know
• Nominal yield volatility (nominal bonds)
• Real yield volatility (ILB)
• Real yield / nominal yield correlation
• CPI volatility
• We deduce CPI ratio volatility
• Correlation are calculated on the forwards
  historical data
• When ATM matrix in defined, a SABR methods can be
  used to calibrate other strikes
• 2007 the year for inflation options market
  liquidity growth. Now we have enough points in
  the ATM matrix to be able get rid of 3F model to
  build it.
• TOTEM is starting contributing a cube (strike,
  maturity, price) every month on Eurpean and
  French inflations caps and floors.

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Macroeconomic and historical data
Take profit from market regulations trough options
The Stabilizer
5y maturity (Euribor 60bp) ? n ? 12 (standard
fixed rate 4.4) n number of months over the
period when EMU yoy inflation is within the
1.50 - 2.80 range

• This strategy is based on the fact that ECB
  target is 2.
• The European inflation is currently 1.83 (May07)
  and 1.85 (Apr 07).
• Since 2000, European inflation has been within
  the 1.50 2.80 range more than 90 of the
  time.
• The market forward prices bet on European
  inflation will remain within the range.

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Conclusion

• Calyon international franchise and know how
  allow to provide taylor made inflation
  opportunities and solutions.
• Calyon has a strong commitment in this asset
  development and therefore, will contribute to
  pricing transparancy
• Seasonality is the trader input and will lead to
  prices dispersion till consensus appears
• Credit risk on linkers obliges to a very
  specific focus.
• Unliquidity should not be considered only as a
  risk but as well as a way to create value for the
  end user.
• As volatility market is developping, the product
  catalog will enlarge in the next years.
• CALYON is the ONE-STOP-SHOP for Global Inflation
  Linked Products