How UK inflation-indexed gilts are priced?
There are two methodologies are used in calculating cash flows for inflation-indexed gilts because gilts have two indexation lags depending on when they were first launched.
An eight-month indexation lag is applied to the calculation for the gilts which were first issued before 2005. The payments on these bonds use the inflation data eight months previously.
The adjusted rate of return is based on the nominal rate of return and the RPI adjustment, where the nominal rate of return is fixed and the RPI adjustment varies.
Two RPI figures are required to calculate inflation adjustment: one is ‘base RPI figure’ that concerns the first issue date of the gilt; the other figure is the RPI applicable to the interest payment date. An example is given as follows to illustrate how this methodology is applied.
Example: 4⅛% inflation-indexed gilts 2030, which was first issued in June 1992 and the relative base RPI is 135.1 (the RPI for October 1991). In order to gain the rate of interest paid in January 1998, the RPI figures for previous May and November in 1998 are also required.
The interest rate of return is as follows:
4.125/2×((RPI for May 1997)/(RPI for Oct 1991))
For the redemption payment per £100 nominal of this bond on maturity is calculated in similar way:
100×((RPI for Nov 2029)/(RPI for Oct 1991))
All the inflation-indexed gilts issued from 2005 onwards have a three-month indexation lag. Distinguished from the above methodology for eight-month lag, the calculation for these inflation-indexed gilts requires the value of Index Ratio.
Reference RPI, an interpolated figure relating to a specific date in the month, is introduced in calculation process. For the first calendar day of any month, the relative reference RPI is simply equal to the RPI for the calendar month three month earlier. The calculation of the reference RPI for the rest days in the month is based on the Ref RPI of the month in which the day falls and the Ref RPI of the following month, using a straight line...