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# Webcast: Modelling Break-Even Inflation

Speaker: Dr David Cox

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A course on this topic is available in London Time Zone, New York Time Zone and Singapore Time Zone

Webcast Agenda

• Practical measures of Break-Even Inflation
• How to derive a real and nominal term structure of rates from bond prices with limited data
• B-Splines and regression: practical uses and pitfalls
• Zero Coupon inflation from nominal and real discount factors
• Zero Coupon inflation from Swaps
• Hands-on example

Learning Outcomes

• Understand the limitations of Break-Even Inflation measures derived from yields
• Understand how to build an accurate real and nominal term structure of interest rates from limited bond data
• Understand the use of B-Splines for interpolation
• Use regression diagnostics to check the validity of the yield curves built
• Learn how to use the yield curves constructed above to derive a Zero Coupon Inflation Curve
• Compare the results with a Zero Coupon Inflation Curve derived from Inflation Swaps

Q&A

1. Why is Break-Even Inflation different when derived from swaps and bonds?
A. This difference has been particularly large in the US market for some years as TIPS have been cheap relative to Treasuries. This gap is beginning to narrow. Bonds are cash instruments and have different balance sheet impact and regulatory treatment to swaps. There are possible tax effects.

2. What is a good measure of the relative value of Index-Linked and nominal government bonds?
A. For a good comparison of the relative value of index-linked and nominal government bonds convert both into a synthetic nominal floating rate note paying a spread over or under Libor by means of an Asset Swap. The inflation linked asset swap uses inflation swaps to strip out the inflation payments from the index-linked bond. Quite often proceeds rather than par asset swaps are used for this purpose because of the large amount of inflation in the market price of the index-linked bond.

3. Can I not use normal cubic spline interpolation when constructing an inflation yield curve?
A. The standard natural cubic spline introduces multicollinearity into the regression. That is why B-Splines are preferred. Steely elaborates on this in his article referenced below.

Visit our Yield Curves Building page - This page uses regression and B-Splines to display the term structure of interest rates and discount factors derived from UK government bonds.

References
Steeley, James M. "Estimating The Gilt-Edged Term Structure: Basis Splines And Confidence Intervals." Journal of Business Finance & Accounting 18.4 (1991): 513-29
Anderson, N. Sleath, J. "New Estimates of the UK Real and Nominal Yield Curves" Bank of England (2001)

Thank you to those attendees who submitted their questions.

LFS offers the 2-day 'Inflation Derivatives and Index-Linked Bonds' programme with Dr David Cox in LondonNew York and Singapore.