Basic Inflation indexed bond question

[bij_30]

Inflation indexed bond pay a periodic coupon that is a product of the inflation index and the nominal coupon rate. Generally the inflation index is calculated with some time lag.

For example - chapter 11 has example on page 6 as:

Consider a 3½% coupon stock issued in February 2000 and redeemed in February 2005. The coupon payments are made each year and are linked to an inflation index with a one-year time lag. The index values each February from 1999 to 2005 are given in the table below.

Year 1999 2000 2001 2002 2003 2004 2005
Index 540 562 584 607 632 657 788

The base month for indexation is February 1999 because of the time lag.
Question: Is the base month always specified in the exam or do we need to assume one?

The coupon payments per £100 nominal are calculated as coupon rate * (past years index / base index). If there was no time lag would the coupon payment be coupon rate * (current year index/ base index)


While calculating real value of the payments why are we considering year 2000 as the base? Is it because the stock was issued in 2000?

Thanks in advance!!

 

[John Lee]

The base month for indexation is February 1999 because of the time lag.
Question: Is the base month always specified in the exam or do we need to assume one?

When inflating the "nominal" coupon/redemption values using the time-lag index you will always use the appropriate time-lag index value that corresponds to when the bond was issued.

The coupon payments per £100 nominal are calculated as coupon rate * (past years index / base index). If there was no time lag would the coupon payment be coupon rate * (current year index/ base index)

Yes

While calculating real value of the payments why are we considering year 2000 as the base? Is it because the stock was issued in 2000?

You can use any date when calculating the real value of the payments actually received. Usually the date the stock is issued or is purchased (if purchased at a later date) is used.

 

[The Warrior]

Thanks guys, this was so useful
But while solving this question I also got a doubt that what is the meaning when real value of payments are calculated keeping the numerator as constant i.e. "2000 index"

So how and when do we decide which one to keep constant - numerator OR denominator?

Thanks,
Warrior

 

[John Lee]

Thanks guys, this was so useful
But while solving this question I also got a doubt that what is the meaning when real value of payments are calculated keeping the numerator as constant i.e. "2000 index"

So how and when do we decide which one to keep constant - numerator OR denominator?

Thanks,
Warrior

When calculating the payments actually received on the IL bond - the denominator will be constant (as you are referencing all the payments back to when the bond was issued).

When calculating the real value of the payments received it is the numerator that is constant (as this is the date you wish to calculate the real value of the payments in).