Inflation- linked products in the Euro area: An AMTE ... final report.pdf · An AMTE working group to standardise, develop and promote the asset class ... Teddy Dewitte (sec gr.2)

Inflation- linked products in the Euro area:An AMTE working group to standardise, develop and

promote the asset class

CHAIRED BY

GUILLAUME AMBLARD

BNP PARIBAS

June 2005

Final report June 2005

2 Inflation-linked products in the Euro area


Inflation-linked products in the Euro area 3

Table of Contents

EXECUTIVE SUMMARY ................................................................................................................5

1 PARTICIPANTS:...............................................................................................................................8

2 DEVELOPMENT OF THE MARKET ..........................................................................................10

2.1 A RAPID DEVELOPMENT OF THE EURO AREA .......................................................................................102.2 A BUOYANT DERIVATIVE MARKET ......................................................................................................122.3 EXPECTED GROWTH OF THE MARKET...................................................................................................13

3 DRIVERS OF DEMAND AND BARRIERS TO ENTRY: CHALLENGES FOR ASUSTAINABLE DEMAND AND A SUCCESSFUL SUPPLY FOR INDEX-LINKEDPRODUCTS ......................................................................................................................................14

3.1 ALTHOUGH INDEX-LINKED MARKETS HAVE RAPIDLY DEVELOPED IN THE PAST FEW YEARS,HISTORICAL PRECEDENTS SUGGEST THEIR EXISTENCE AND SUCCESS REMAIN VULNERABLE. ..............15

3.2 LEGAL AND TECHNICAL IMPEDIMENTS ARE NOW LIMITED; HOWEVER ACCOUNTING ONES REMAIN,WITH RESPECT IN PARTICULAR TO THE NECESSARY BROADENING OF THE INDEX-LINKED MARKET......24

3.3 THE WORKING GROUP WOULD RECOMMEND A LIST OF MEASURES AIMED AT FACILITATING THESMOOTH FUNCTIONING OF THE INDEX-LINKED MARKET. .....................................................................27

4 STANDARDISATION AND ENHANCEMENT...........................................................................28

4.1 LITTLE IMPROVEMENT IS NEEDED AS FAR AS UNDERLYING INDICES ARE CONCERNED, GIVEN THEEXPERIENCE OF STATISTICAL INSTITUTES, HOWEVER THE WORKING GROUP SUGGESTS SOMECLARIFICATION ON A LIMITED NUMBER OF ISSUES...............................................................................29

4.2 HARMONIZATION IN THE STRUCTURE OF INFLATION-LINKED BONDS IS GRADUALLY IMPROVING,YET A MAJOR DIFFERENCE REMAINS FOR THE PROTECTION OF THE PRINCIPAL.....................................30

4.3 THE DIFFICULT QUESTION OF THE BETA IN MIXED FIXED INCOME PORTFOLIOS....................................334.4 INFLATION-LINKED BONDS DOCUMENTATION: ....................................................................................35

5 PROMOTION AND DEVELOPMENT OF PRODUCTS............................................................36

5.1 INCREASING TRANSPARENCY AND LIQUIDITY OF EXISTING PRODUCTS ................................................365.2 TO PROMOTE A BROADER PRODUCT RANGE, THE WORKING GROUP HAS LOOKED AT SEVERAL

POSSIBLE INFLATION FUTURE CONTRACTS...........................................................................................38

6 RECOMMENDATIONS AND ACTION PLAN ...........................................................................39

7 ANNEX..............................................................................................................................................43

Annex 1. Investor Survey and results..................................................................................................................44Annex 2. Auditor Survey .....................................................................................................................................55Annex 3. Bank Survey and results.......................................................................................................................59Annex 4. CNO recommendation on inflation-linked bonds ................................................................................61Annex 5. Plan for Increased Awareness of Inflation linked Bonds.....................................................................63Annex 6. Proposed content for AMTE inflation-linked website ..........................................................................64



Executive Summary

Euro-denominated markets for index-linked products have developed at a rapid pace in the last twoyears, with a commitment of an increasing number of sovereign and semi-sovereign issuers to populatethe real curve. Today, almost all segments of the real curve offer good liquidity and opportunities forinvestors. The main drivers were increased demand following changes in regulations and a response tothe specific needs of some investors.

In November 2004, AMTE set up the "inflation-linked products" working group dedicated to theharmonisation, standardisation and promotion of innovative Euro debt products.

The goal of this study is to prepare a reference document for all current and potential participants in theinflation-linked market and to recommend measures to further standardise and foster the development ofthis new asset class. It aims at opening the market to new participants (whether investors or issuers) andto increase the liquidity and transparency of the European bond and derivative inflation market.

Chaired by Guillaume Amblard of BNP Paribas, this working group includes over 30 organisations thatare representative of the major participants in the field, being issuers, investors, investment banks orother active participants such as system providers and advisory bodies. Given the number and diversityof participants and the scale of the tasks at hand, the working group has been subdivided into four sub-groups to increase the overall efficiency. Each workshop has reviewed the existing situation in its domainand has proposed an action plan. The four sub-groups are:

- Drivers of demand and barriers to entry - chaired by Christophe Duval-Kieffer of Crédit Suisse First Boston

- Development of a payer market – chaired by Greg MacKay of The Royal Bank of Scotland

- Standardisation and enhancement - chaired by Jean-François Borgy of IXIS Corporate & Investment Bank ·

- Promotion and development of products – chaired by Benno Weber of Crédit Suisse Asset Management.

AMTE members of the working group have tried to assess the sustainability of such a rapid developmentof the inflation-linked market in the medium run, as history suggests that some countries eventuallyabandon their index-linked issuing programs. They have also reviewed the standard characteristics ofinflation-linked bonds within the European market, with a focus on the need for principal protection atmaturity and on risk and beta reporting. Finally, the group looked at ways to develop further the inflation-linked market through the promotion of new products derived from bonds and plain vanilla derivatives.

Given the similarity of topics facing issuers and investors, the first two groups have decided to merge afterreviewing situations that were specific to their group. Their reflections and contributions have focused onthe factors allowing current trends to be maintained and on the residual obstacles to investors and issuersthat might pose a threat. Some transversal issues have been addressed by different groups. Given thenature of index-linked products and their differences relative to conventional bonds, residual obstaclesshould not be underestimated. Barriers that might affect investors or new issuers could make thedifference between a very successful inflation-linked market that increases its role in financial markets tothe benefit of all, and an inflation-linked market that is considered to be a marginal asset class.



The working group has also conducted surveys amongst investors, banks and auditors on euro-denominated inflation-linked bonds.

The investor survey aimed firstly at identifying the current obstacles that weigh on inflation-linkedinvestment, whether regulatory, accounting, fiscal, legal or system-related. It was also an attempt toassess the demand for new inflation-linked products such as corporate inflation-linked bonds, inflationfutures and other new inflation-linked instruments. With over 60 answers across Europe and the US, thesurvey’s results give a good overview of the current state of the investor base. However, it mayunderestimate the remaining obstacles or demand for new products since it mostly focuses on investorsthat are already active on the inflation-linked market.

The bank survey targeted the 20 most active banks in the inflation market and tested their appetite for afixing rate on inflation breakeven. The high response rate allows the working group to propose the fixingof new indices.

Finally, the auditor survey was sent to the four major audit firms with the aim of having a clearer view onthe accounting treatment of inflation-linked products, whether bonds, derivatives or loans. The absence ofa clear consensus in the auditors’ answers leads the working group to seek alternative methods ofreceiving clarification of the IFRS treatment of such products.

Based on the conclusions of this survey and the contributions of all members, the working group hasmade a series of recommendations aimed at:

increasing transparency and harmonisation, by:- assessing the impact of the new IAS39 framework on index-linked products; it is the most

urgent concern, in the view of the working group,- establishing a clear commitment from sovereign issuers to steadily grow the inflation-linked

market and create a liquid real EUR curve, the pre-requisite for more activity from corporatesand financials,

- working with the UK and other future European issuers to consider embedding a floor in theprincipal redemption of their inflation bonds to attract the broadest possible range of globalinvestors to their debt,

- recommending that a fixed beta should only be used for regulatory reporting purposes and forinvestments on a long-term basis. The working group stresses that transparent reporting ofrisk involves reporting both nominal and real rate exposures;

developing awareness of the product, by- asking Eurostat to publish the ex-tobacco index itself alongside the Year on Year figures (or

% Month on Month). Bloomberg, Reuters and other providers should then publish this indexin real time, and publish a consensus survey ahead of the release,

- liaising with the press to improve communication of “ex-tobacco” index releases used by thelinkers markets as opposed to current focus on headline or core inflation releases (using UKONS as an example),

- creating a web site on inflation-linked products, hosted by AMTE;



increasing demand, by- reforming existing regulations that do not seem adapted to the specificity of index-linked

securities, especially in France, Germany and Spain,- working with regulators to focus more on the certainty of real cash flows in IL bonds than on

the uncertainty of nominal cash flows, and hence, as the ECB, to treat inflation bonds as fixedrate bonds (which they are in real terms) and not as equity;

developing new products, by- implementing the fixing of a Constant Maturity Breakeven rate on a 10-year maturity, similar

to the Constant Maturity Swap existing for nominal swaps, involving all possible providers.



1 Participants:

Brice Benaben (sec gr.3) [email protected] AmroTeddy Dewitte (sec gr.2) [email protected]

Agence France Trésor Nicolas Sagnes [email protected] IM Laurent Gonon [email protected] de France Alexandre Chailloux [email protected]

Ed de Waal [email protected] BankRaoul Salomon [email protected]

Bloomberg Peter Jones [email protected] Amblard(chair)

[email protected]

Bradley Anderson [email protected]é Cros (sec gr.1) [email protected] Guerin-Cribier(secretary)

[email protected]

Katja Jarvis [email protected] de Lambilly [email protected]

BNP Paribas

Philippe Challande [email protected] Asset Management Isabelle Vic-Philippe isabelle.vic-philippe@ca-

assetmanagement.frHeithem GANOUNI [email protected] Helias [email protected]

Citigroup Jean Lepic [email protected] Suisse AM Benno Weber(chair gr.4) [email protected] Christophe Duval-Kieffer

(chair gr.2 and secretary)[email protected]

Steve Scott [email protected] BankMarc-Olivier Lebeau [email protected]

DWS Investment GmbH Leif Bjurstroem [email protected] Fournier [email protected] Remay [email protected]

European Investment Bank David Clark [email protected] Sachs David Lofthouse [email protected] Iwan Lont [email protected] - CCF Philippe Laroche [email protected] CIB /Comité deNormalisation Obligataire

Jean-Francois Borgy(chair gr.1)

[email protected]

Merrill Lynch Loic Guilloux [email protected]



MTS Next Scott Stark [email protected] Banques Populaires Laurent Chemla [email protected] Greece Francis Dassyras [email protected]

James Kneller [email protected] Bank of ScotlandGreg Mackay (chair gr.3) [email protected]

RWE Peter Matza [email protected] Angelo Bonetti (sec gr.4) [email protected]

Sylvain de Forges [email protected] Daumal [email protected]

World Bank Ivan Zelenko [email protected]

ObserverEuropean Central Bank Martin Perina [email protected]



2 Development of the Market

2.1 A rapid development of the Euro area

The “modern era” of inflation-linked bonds started with the issuance of UK index-linked Gilts in 1981,followed by Australia, Canada, Sweden, and the US in 1997. In this context, issuance in the Euro area ismore recent, with France’s launch of the OATi-2009 in September 1998, followed by the OATi-2029 in thefollowing year.To date, the US TIPS remains the largest inflation bond market, with an outstanding amount ofEUR 219bn (or EUR 267bn including indexed growth to date), while the EUR market has been thesecond largest since 2003 in terms of notional, with currently outstanding sovereign linkers of over EUR121bn (or EUR 144bn including indexed growth). In 2005 it will overtake the UK market in terms of marketcapitalisation. In 2003, for the first time, EUR inflation issuance exceeded that of the US and it hasremained at a high level since then.

No. ofbonds

Notional(bn ccy)

Notional(bn EUR)

MarketCap.(bn EUR)

AverageDuration

% ofIndexedDebt(Notional)

% ofIndexedDebt(MarketCap.)

IssuanceYTD 2005(bn EUR)

Expectedissuance2005 (bnEUR)

EMU 13 121 121 144 9.2 3.5% 3.9% 22 42US 16 263 219 267 8.8 9.1% 10.1% 32 64UK 9 46 70 158 10.9 16.5% 30.9% 4 10Sweden 5 193 21 28 10.7 25.6% 29.8% 0.7 <2Japan 4 1400 11 11 9.0 <1% <1% 4 11global 442 608 62.7 129

The most natural investors for OATis (indexed to the French ex-tobacco CPI) were initially domestic, butthe availability of EUR-denominated inflation protection also attracted other Euro area investors, whoeither accepted the basis risk between French and their domestic inflation, or looked to the rapidlydeveloping inflation derivatives market for their specific needs. It quickly became apparent that marketsfor country-specific indices (apart from France) would not be available soon enough; however the Euroarea HICP (i.e. the basket of all EUR-members weighted by their final private consumption) establisheditself as a benchmark for the derivatives market. By mid-2000 this market had seen its first strong periodof growth with the issuance of retail and insurance products.In the meantime, other French semi-sovereign issuers entered the market for French inflation: CADES in2000 and CNA in 2001. This meant that by 2001 a more populated real curve (with reasonable liquidity inthe non-government issues) for French inflation was available. This also led to a steady increase in thedemand for Euro area HICP on a wider range of derivative products and maturities.The growing imbalance between demand and supply on the Eurozone index was noted by the FrenchTreasury (AFT), which took the opportunity to issue a new 10-year bond indexed to Eurozone HICP(OATei 2012) in October 2001. In order to be consistent with the French index, AFT decided to use theex-tobacco index even though the ECB’s inflation target is defined in terms of the headline HICP. The ex-tobacco index has now become the reference for the Eurozone inflation market, both for bonds andderivatives.



Figure 1: Growth of the European inflation-linked bonds

0

20

40

60

80

100

Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-050

10

20

30

40

50

60Inflation Debt

Monthly Turnover

bn EUR bn EUR

OATei-12OATi-13

OATi-29 OATei-32

BTPei-08

OATei-20

BTPei-14

GGBei-25

OATi-11

BTPei-35OATei-15

BTPei-10

Source: AFT and BNP Paribas estimates for bonds issued by Italy and Greece

In the following year, the AFT extended the European inflation curve to 30 years by issuing the OATei-2032. In another illustration of the strong link between the inflation bond and derivatives market, thepricing for this issue in terms of the long-end EUR/FRF inflation spread was derived from the levels in theinflation swap market and its implied forward spreads.2003 marked a new stage in the maturity of the inflation market. France auctioned a new 10-year FRFlinker (the OATi-2013, the first non-syndicated inflation issue in the Eurozone), while both RFF (theFrench rail network) and Greece issued long-dated inflation-linked bonds (2023 and 2025) indexed to theEurozone HICP excluding tobacco. Increased liquidity had now attracted a wider range of investors,including relative-value players, and market volumes had reached over 10bn/month. Furthermore, achange in the regulation for French insurers in December 2002 (who could previously not account for thenotional accretion of linkers) triggered the first large-scale investment programmes in this market.In addition, the market saw a surge in inflation-linked MTN issuance (over EUR 9bn), most of which wasconcentrated in the 5-year sector and placed mostly with Italian investors. The bond curve offered Frenchand Eurozone inflation-linked benchmarks in the 10-year and 30-year maturity, whilst the strong interestin the 5-year maturity called for a new point. The Italian Treasury took advantage of the risk premium onthis part of the curve, and issued the BTPei-2008. The resulting liquidity on shorter maturities attractedfurther relative-value players; in particular since it allowed them to express views on the short-term carryoutlook and EUR/FRF inflation differentials.In 2004 and 2005, AFT and the Italian Treasury confirmed their commitment to this new asset class bybecoming frequent issuers of benchmark lines at key points of the curve. The European inflation markethas now reached the critical size and liquidity to support large asset/liability management programmes.



Figure 2: Public inflation-linked bonds outstanding in the euro area

0

3

6

9

12

15

2005 2009 2013 2017 2021 2025 2029 2033

bn BTPei Credit EURGGBei Credit FRFOATei Credit ITLOATi

2.2 A buoyant derivative market

Figure 3: Monthly turnover on inflation swaps

0

5

10

15

20

25

Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05

InterbrokerTotal

bn EUR

Source: ICAP, BNP Paribas’ estimates for Total

As seen in the above chart, the increase in trading volume and liquidity in the European inflation markethas been dramatic. The Euro denominated market is now the most advanced inflation market in terms ofproducts and market participants. At the same time, it is the most liquid for derivatives.However, the size and nature of the bond market is still different from the derivatives market. While thebond market sees a high trading activity on a daily basis, the average ticket size is below EUR 100m. Incontrast, ticket sizes on the derivatives side tend to be larger (EUR 100m to 1,000m), but trades are notas frequent. This demonstrates how closely linked and complementary both markets are: the bond marketwill influence the short-term movements of the swap market; on the other hand, derivative flows mayresult in changes in the valuation of the cash market. Natural payers of inflation have a preference forlonger maturities. Receivers use cash and derivatives, with retail interest focused at the short end, butmost strategic end-investors favouring the 10-30 year segment.The strong link between inflation bonds and derivatives also made it necessary to align these markets interms of documentation (for example, the use of non-revised indices for derivatives), but their regulatoryand accounting treatment still needs more co-ordination.More recently, the derivatives market has seen renewed interest in national inflation indices, in particularon Italian, Spanish, Dutch and Belgian inflation. This has been driven by “local” inflation payers (e.g.



infrastructure projects, real estate financing), as well as by demand from pension funds and retailinvestors. While large-scale issuance of national-index linkers still a distant prospect, the derivativesmarket will again play its role in matching supply/demand and valuing risk premia for these indices.

2.3 Expected growth of the market

Demand is expected to grow even faster than before: Historically, French investors (insurers, bank ALMsand mutual funds) have been the biggest investors in continental Europe. Yet pension funds fromcontinental Europe have been more active since 2001, with the Netherlands leading the way in theprovision of a private pension system. Pension reform efforts in France, Italy and Germany will eventuallyfurther bolster this sector, since life insurers need to hedge long-term inflation indexed liabilities. In aneffort to estimate the potential size of inflation demand, an overall asset allocation of 5% in these productsstill seems conservative for pension funds. In Britain, relatively expensive indexed Gilts account for over8% of pension funds’ managed assets and for 35% of their fixed-income assets. When applied to French,Italian, German and Benelux institutional investors alone, a hypothetical allocation of 5% would alreadyproduce a figure of over EUR 360bn today, compared to the current outstanding of just EUR 121bn.� New supply: Germany should soon join France, Italy and Greece. Furthermore, other issuers,

including supra-nationals, agencies and corporates, are willing to enter the market in the mediumterm. Indeed, Veolia has recently launched the first corporate inflation-linked bond of the Euro area.

� There is further potential for new inflation payers. Future revenues from infrastructure projects(motorways, bridges, etc.) are often linked to domestic inflation. Similarly, the rental income ofproperty owners is frequently linked to inflation by law (e.g. in Italy, Belgium and the Netherlands,while in France, there is a project to link it to inflation), while the tax revenues for municipalities aremore or less linked to inflation. These market players might increasingly hedge their inflationexposure by entering the inflation market as payers.

� More indexation: Historically and culturally, continental Europe has always been wary of indexation, inparticular in financial products. This is in clear contrast to the UK. However, as new regulation andaccounting standards lead to a detailed analysis of assets and liabilities, more and more investorsand issuers are realising the inherent indexation they are already exposed to. The first large-scaleexample of this is the partial indexation to inflation of Livret A (French savings account), the TFR(index-linked severance payment) in Italy is another one.

� More indices: The demand for domestic inflation indices should attract issuers following the Frenchexample. A domestic index is even more suitable for public debt management and the availability ofcross-index spreads will boost liquidity for the entire market. There is a compromise between thenecessary harmonisation of the market that would require a single index and the demand fordomestic indices from investors.



3 Drivers of demand and barriers to entry:Challenges for a sustainable demand and a successful supply forindex-linked products

Euro-denominated markets for index-linked products have developed at a rapid pace in the last twoyears, with an apparently persistent commitment of an increasing number of sovereign and semi-sovereign issuers to populate the real curve.

AMTE members of the working group on demand for index-linked products represents a rather broadgeographical range of investors coming from Germany, France, The Netherlands, the UK and Italy.

Their reflections have focused on the factors allowing for such trends to be maintained and on theresidual obstacles to investors that might pose a threat. Residual obstacles are indeed not to be under-estimated; barriers that might affect investors could make a difference between a very successfulinflation-linked market increasing its role in financial markets for the benefits of all and an inflation-linkedmarket considered as a marginal asset class.

The working group has also conducted a survey amongst investors in Euro denominated inflation-linkedbonds1. The survey was first aiming to identify the current obstacles that weigh on inflation-linkedinvestment, whether regulatory, technical or legal. It was also an attempt to assess the demand for newinflation-linked products such as corporate issuance, inflation futures and other new inflation-linkedinstruments. With over 60 answers across Europe and the US, the survey results give a good overview ofthe current state of the investor base. However, it may have underweight remaining obstacles or demandfor new products since it mostly focused on investors already active in the inflation-linked market.

Indeed, inflation-linked products present by definition an opportunity cost with respect to conventionalbonds – the inflation premium - and regulatory, accounting and legal obstacles to investing in theseproducts are therefore all the more harmful to their developments. However, they also offer properties of“public goods” which, although they do not justify per se the development of inflation-linked markets,would make it costly in terms of overall social welfare to eventually renounce them.

Index-linked products provide the market with a certainly imperfect but easily available measure forinflation expectations on many different maturities; in a crucial feedback, such measures play animportant role in anchoring inflation expectations, which become common knowledge for all marketparticipants. They are therefore not only a monitoring tool with informational value but could also becomean anchor for price expectations in the economy, for instance in wage negotiations, provided liquidity issufficient. The challenge goes beyond the functioning of the financial community, in the view of theworking group.

1 See survey in annex



3.1 Although index-linked markets have rapidly developed in the past few years, historicalprecedents suggest their existence and success remain vulnerable.

3.1.1 Demand for index-linked products has been supported by an emerging fundamental needfor an insurance against the inflation risk, but also by a demand created by changes onindexation regulation on some parts of the European economy. Our assessment ofdemand suggests that, in the euro area, pure demand for insurance against inflation risk isnow on par with the demand that arises from – or is constrained by – regulatory changeson indexation.

Index-linked bonds have been promoted as an instrument of choice for transferring real income inthe future; regulations on the funding requirements of pension funds should increase their role asthey provide ideal features for long-term dynamic asset-liability matching, however surveys ofdemand suggest that it is not yet the prevailing force driving demand for inflation-linked products.

The Dutch investor base, in particular the pension funds, is potentially the principal source of inflationpurchase in the coming years given the change of regulation towards a much more restrictive regimeaimed at reducing the risk of under-funding. Inflation products, although not specifically mentioned in thenew pension regulation, are appropriate particularly with respect to the reduction of the share of equityholdings.

In France, the promotion of de-centralised, individual pension instruments (PERP) and their design,particularly in terms of investment rules, should result in increasing demand for index-linked products.

In Italy, employees are entitled to lump sum termination indemnity payments upon leaving. Thisseverance payment is called "Trattamento di fine rapporto" (TFR). The employer retains a fixed fraction(1/13) of each employee’s annual salary. The accumulated resources yield an interest rate, made of afixed rate of 1.5%, plus 75% of inflation, and there is some flexibility (for first house buying, healthemergencies...) to withdraw the accumulated capital before termination. Recent reforms of the pensionsystem in Italy are based on voluntary transfers (with the formula "silence is consent", though) of the TFRflows (not the stock) to a supplementary pension fund. This should lead to transfers estimated atapproximately €10bn per year to pension funds, and likely provide an implicit demand for securities thatare replicating the TFR return - inflation-linked bonds, in particular.

Denmark used to have an inflation-linked mortgage bond market; there would be no obstacles toresuscitate an actively traded inflation-linked market, given the technical expertise already gained. On thecontrary, the changes in the mortgage funding methods might even force Danish investors to find newinvestment opportunities soon and inflation-linked bonds of the euro area are a likely target given thegood correlation of the euro area HICP with the Danish CPI. The only barrier is the maximum portion ofEuro denominated debt in Danish portfolio (60%). It is worth remembering however that the current lackof attractiveness of domestic inflation-linked markets in Denmark mostly comes from a less favourable taxsystem than was previously the case. Nevertheless, survey evidence gathered by the working groupsuggests that Danish asset managers are very active on euro inflation-linked products.



According to the survey performed by the working group among investors2, pension funds in Europe arenot yet systematically investing in index-linked products although they admit managing inflation-linkedliabilities. Results of the survey suggest that pension funds in the euro area, in particular in theNetherlands and Finland do not invest in inflation-linked products for asset-liability managementpurposes, but rather consider inflation-linked instruments as an opportunity for diversification. There istherefore considerable room for improvement as far as the purchasing of inflation-linked securities forasset-liability management purposes is concerned. If such were the case, regulators and issuers wouldhave to be aware of the potential valuation distortions that might stem from very binding asset-liabilitymanagement constraints.

Although index-linked products offer attractive features for the protection of the real value oflong-term liabilities, it remains the case that a harmonious development of the whole real curve –and not only its long-term segment – should remain a key concern for regulators.

The obvious example of the impact of the regulation on the funding requirements of pension funds is tobe found in the UK; although UK linkers are not euro-denominated, there are interesting parallels to drawon where the euro market might be headed. The attention of the working group on demand was focusedon the impact on valuations of a rigid and systematic promotion by regulators of explicit indexation.

Essentially, to match liabilities, UK pension funds are keen buyers of long-dated UK bonds (bothconventional and inflation linked), thus lending the yield curve a systematic downward slope. The problemwas at its most critical towards the end of the 1990’s, under the law of the Minimum FundingRequirement. This was created by the Pensions Act 1995. The rules came into force in 1997, and weredesigned to protect the value of defined benefit occupational pension schemes. The rules required nearlyall private-sector defined benefit schemes to make up any shortfalls between assets and a minimum leveljudged necessary to meet obligations, within prescribed time periods.

Assets were valued at market levels; liabilities for pensions already in payment (and, for non-retiredmembers, liabilities after retirement) were discounted at Gilt yields. Naturally, cautious trustees tended torecommend that assets were held in the form of long Gilts so that, as far as possible, assets matchedliabilities. In this way, the risk of failing the MFR test would be minimised. These rules generated gooddemand for long inflation-linked bonds to begin with, but eventually the low yields stifled demand from thewider investment community.

Partly because of the market distortions, a commitment was made in 2001 to abolish the MFR law; at thesame time there was diversification out of long Gilts into other assets (e.g. credit), and thus inflation-linked Gilts (and also conventional Gilts) became more accessible in terms of price. The net result of allthese regulations is a current downward slope in the real UK curve. Although the current batch ofregulations does not direct funds into long Gilts as strongly as did the MFR, there are clearly stillsignificant effects, leaving low real yields a disincentive to investment at long maturities.

Demand for index-linked products has also resulted from the explicit indexation to consumerprices of tax-exempt saving schemes, the most noticeable example being France and the so-called “livret A”.

2 Note that the survey is not intended to provide a perfect quantitative image of the industry; however, respondents to the surveyrepresent almost a quarter of the total market capitalisation on inflation-linked securities in euros.



In France, the formula used to calculate the rate paid on savings accounts known as “livret A” nowexplicitly includes a reference to the annual (French) inflation rate. Such explicit indexation mechanismshave had an impact on the asset-liability management of the financial institutions in charge of payinginterest on such saving schemes, boosting demand for index-linked bonds and also inflation swaps.Given the volumes on such saving schemes, the question arose as to what share of the demand forindex-linked products was created by manipulating indexation regulation.

If such changes on regulated savings were to occur again, the working group would welcome a smoothapproach to the management of such changes, giving market participants enough time to fully understandthe consequence of regulatory changes.

At the end of the day, the promotion of explicit indexation in tax-exempt schemes can be at least partlyinterpreted as an indirect tax incentive to the purchasing of such products; some members of the groupargued that they “find it preferable to avoid market distortions that could stem from regulations thatexplicitly favour inflation-linked products. In the end these moves can easily be viewed with suspicion(e.g. when might the special measures be removed or, if removed, when might they be reapplied). Thesector may then never gain full acceptance on its own merits, alienating certain parts of the investmentcommunity.” It is better, they argued, to approach the lobbying for linkers to be placed on an equal footingwith conventional bonds – for example in the area of tax. The Danish example and the collapse of theindex-linked market after the removal of their relative tax advantage would support this view.

The working group agrees however that a large fraction of current demand responds to thefundamental need to hedge investments against the inflation risk; this bodes well for the future ofthe index-linked market, in particular if the range of available products is broadened.

Some form of fundamental demand has probably emerged, supplementing and then eventuallysuperseding regulated demand. Pieces of evidence on demand appear rather re-assuring; of course,overall turnover statistics on bonds and swaps show rapid progress (see market outlook) but also bid-to-cover ratios to French auctions are rather stable across maturities and the structuring of index-linkedEMTN has shown resilient growth, once the impact of increasing sovereign issuance is taken intoaccount.

The survey conducted among European investors also shows that investors that feel that they aremanaging inflation-linked liabilities3 are all investing on the inflation-linked market, regardless of theircategory or of their nationality. Of remaining investors, more than half is anyway investing in inflation-linked securities for diversification purposes.

3 Those who answer “yes” to the question “are you currently managing explicit or implicit inflation-linked liabilities?”



Figure 4: Bid-to-cover ratios on French auctions of inflation-linked bonds (source: AFT)

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

2/4/99

6/4/99

10/4/

99

2/4/00

6/4/00

10/4/

00

2/4/01

6/4/01

10/4/

01

2/4/02

6/4/02

10/4/

02

2/4/03

6/4/03

10/4/

03

2/4/04

6/4/04

10/4/

04

Table 1: Index-linked EMTN (source: MTNi)

2003 2004Reference index USD, mios N.MTNS Reference index USD, mios N.MTNSEuro area HICP ex tobacco 6478 57 Euro area HICP ex tobacco 2104 40French inflation excluding tobacco 2284 10 French inflation excluding tobacco 1605 4Italian CPI 1043 8 Italian CPI 936 2US urban CPI 663 28 Denmark CPI 821 4FRN to euro area HICP ex.tobacco 517 5 Japanese CPI 472 1UK RPI 435 4 Amortising Italian inflation index linked 247 1Hybrid euro area HICP+ digital euribor 370 1 Swedish CPI 195 4Euro area HICP (total) 227 4 UK RPI 185 1Hybrid euro area HICP + equity basket 55 3 US urban CPI 182 15Amortising Belgian inflation 39 1 Spanish CPI 141 3Hybrid French CPI+ CMS 31 1 Hybrid euro area HICP + equity basket 99 1

FRN to euro area HICP ex.tobacco 72 1Total 12142 Euro area HICP (total) 62 1

Eurozone HICP & CMS 57 3Eurozone HICP & Credit 19 1 Italian CPI&Italian Credit 19 1Eurozone HICP & Digital Euribor 12 1Eurostoxx50 & Eurozone HICP 6 1

Total 7234



Final demand has been mostly driven by insurance companies and asset managers.

One particularly interesting result of the investor survey is to emphasise the role of insurance companiesin the demand for index-linked products, more specifically in France and Italy; the stability of resourcescollected on non-life insurance and their correlation to inflation has made index-linked productsparticularly attractive for insurance companies, which remain the main buyers of inflation-linked securitiesfor asset-liability management purposes – by contrast with pension funds which are not quite asadvanced on that front as one would expect. Interestingly some insurers suggest that they are using verylong-dated inflation-linked securities to match very long liabilities.

Figure 5: distribution by type of client of the OATei 2032 (source: AFT)

OATei 2032

Asset managers + funds36%

Bank ALM + bank portfolio

22%

Retail0%

Insurance companies + pension funds

30%

Central banks0%

Corporate3%

Hedge funds9%


OATei 2020

Asset managers + funds31%

Bank ALM + bank portfolio20%

Retail1%

Hedge funds8%

Corporate1%

Central banks10%


29%




OATei 2012

Asset managers + funds45%Bank ALM + bank portfolio

20%


20%

Central banks3% Retail

1%Corporate

2%Hedge funds

9%

There remains room for product diversification, in particular in terms of underlying indices,although the working group would favour a very gradual emergence of alternative indices.

Until now, macro-economic conditions have been rather favourable to the development of fundamentaldemand, with unexpected price shocks creating an incentive to hold an insurance against the inflationrisk. The question remains as to how fast the market would develop in less favourable macro-economicconditions.

One possible way of diversifying demand and perhaps growing it is the development of index-linkedbonds on alternative indices; there is however a trade-off between focusing on the liquidity and thebenchmark properties of one index and multiplying reference indices. As some members of the workinggroup argue, the true nature of this trade-off between one benchmark index and several indices involvestraded volumes and market liquidity. “Many investors have domestic inflation liabilities. So we couldassume that this kind of investors would prefer to have domestic inflation-linked bonds. However they are"buy and hold" investors and don't provide liquidity to the markets. Other investors are buying index-linkedbonds for diversification purposes. They expect liquid bonds”.

Although the working group welcomes the notion of multiple reference indices, it remains sceptical on theability of the euro-denominated market to generate enough extra demand to guarantee the liquidity ofanother underlying index after the French CPI and the euro HICP. It is all the more true that indexdiversification would principally help asset-liability management, which mostly consists in buy-and-holdbehaviour. Nevertheless, there are already instances of investors showing interest for domestic indices:the investor survey presents evidence of an interest for Dutch and German domestic indices.

At this juncture, the working group considers that inflation differentials across euro countries are anopportunity rather than an obstacle. In the short run, most issuers should concentrate on euro inflation



index rather than domestic inflation. As noted by a member of the working group, “issuing on euroinflation should be the default position, and domestic-linked paper should be sold only if liquidity situationpermits”. A few governments in the euro zone have an issuance program that could allow them to issueat the same time euro and domestic inflation. A member of the working group notes that “if one countrywith high inflation was to issue domestic inflation-linked bonds, it would enable investors from other highinflation countries to hedge their inflation risk”.

A final element needs to be added on the existence of fundamental demand for the hedging of short-terminflation risk. In the view of the working group, the US precedent and the relative and repeated failure ofthe market for short-term CPI futures would suggest caution in the approach to the market for short-terminflation hedging. The design of adapted short-term inflation futures is probably a crucial element and itremains the case that for obvious reasons the market lacks experience in the valuation of very short-dated inflation-linked bonds. As more and more inflation-linked bonds mature, the issue will become moreand more relevant, given the high volatility of very short-term inflation and the valuation of seasonality.The working group would certainly suggest preliminary surveys and increased awareness to this fact.

The working group also underlines the fact that the creation of short-term inflation future contract on euroinflation excluding tobacco would definitely impose this index as the benchmark index for the euro areaand, maybe, reduce liquidity and turnover on potential issues of domestic inflation-indexed securities andproducts. At this stage in terms of development of the market, the trade-off needs to be assessed.

3.1.2 Historical precedents suggest that the creation of index-linked markets can respond toopportunistic considerations and might be at risk in environments of more buoyant publicfinance. Investors remain vigilant as to whether the commitment of issuers to thedevelopment of index-linked markets will be upheld. They also expect more drive on thecorporate side in the near future.

The first instance in which the issuing of index-linked securities could be at risk follows asignificant improvement in the overall fiscal position; historical precedents suggest that index-linked bonds would be the first to be abandoned, as governments refocus on nominalbenchmarks.

The first example is Australia that has a very strong fiscal position. The total amount of Commonwealthgovernment securities on issue has been shrinking over the last 6 years. From approximately $A110bn ofbonds on issue in 1997, there were about $A55bn on issue on 30 June 2004.

In 2003, the Government decided to conduct a review of the Australian bond market, with a view toeliminating all outstanding government debt (this would be funded by the sale of the government's 50.1%share of Telstra, the Australian telecommunication company).

However, it then decided (after considerable consultation with interested parties) that in the future it wouldissue sufficient Treasury bonds to support the Treasury bond futures market. It decided that the costsassociated with managing interest rate risk across the economy would be higher without a Treasury bondfutures market. So the size of the Australian Commonwealth Government Bond market should stayaround $60bn for the next few years (at least while the Budget remains in surplus).



At the same time, it announced (in May 2003) that it would suspend the issuance of Treasury IndexedBonds although it had committed earlier to keep 10-15% of new issuance to the indexed program4. As at30 March 2005, there were approximately A$6.6b of outstanding indexed bonds, in 4 different issuesmaturing every 5 years between 2005 and 2020. At this stage, the Treasury has not announced any plansto buyback these securities - as such, it is assumed that they will all be held to maturity. Pension fundsand banks probably own most of these bonds. While these institutions probably have a demand for suchproduct, it has been largely stymied by lack of supply, with hardly any replacement issuer.

The example of the US is also significant. The TIPS program was started in January 1997, but was verymuch under scrutiny as the US budget moved into surplus. The cost-effectiveness of the program wasfrequently re-assessed. In February 2001, the bond market association suggested to drop the TIPSprogram: “to date, calculations suggest that the Treasury has made USD 1.5bn extra under the programcompared to what would have been paid if nominal securities had been issued. Other estimates of theincremental cost of the program are even higher. Continued issuance of indexed securities in an era oflarge budget surpluses only exacerbates the liquidity problem in the benchmark nominal debt programs.”In 2004 however, the Bond Market Association recommended that the US Treasury issue a 20-year TIPS.

The working group does not of course envisage the emergence of fiscal surpluses in the near future as arisk weighing on the issuance of inflation-linked securities. However, past experience drawn from theexamples of Australia and the US suggest that there is an element of opportunism in the breakdown ofgovernment debt between index-linked and conventional debt.

On this particular front, it would expect sovereign issuers to renew their commitment to regularlygrow the market.

Currently index-linked debt is 10.1% of French marketable debt (EUR 87bn in nominal terms) and 2.9% ofItalian debt (EUR 36bn), vs. 7-8% in the US.

Such a commitment, according to the working group, is twofold: it consists partly in a commitment to growabsolute volumes and partly in a commitment to maintain liquidity on the whole real curve. It has beenobserved that some specific bonds can trade unusually expensive on the repurchase market. To satisfyboth these aspects of the commitment, the approach favoured by the French treasury offers aninteresting compromise, combining the announcement of a minimal share of debt issued in index-linkedsecurities per year and a regular auction schedule. The working group would welcome the extension ofsuch an approach to other issuers of inflation-linked securities, as seems to be the case. As one memberargues, “the target is to have an inflation-linked market working like the nominal market. Firstly, thismeans a commitment to continue issuing inflation-linked bonds in the future. Then it means transparencywith a well-known issuance program: size and date of auctions, ideally the kind of maturity”.

Another member underlines that when referring to “transparency, one should also refer to the auctionprocess by which some inflation-linked issues are brought to the market at levels that are way aboveprevailing secondary market levels. Although advantageous for the issuer, it is difficult to explain this typeof supply/demand dynamic to a potential new client. In feedback from some of our clients, this opaqueprocess is what keeps them from actively participating in these auctions”.

4 “Australia’s Experience with Index Bonds” paper presented by Mr Peter McCray, Assistant Secretary, Debt Management Branch,Treasury – 10 June 1997



Finally, some argue that an even more advanced form of transparency would consist in committing toregularly issue on a given maturity – for instance 10-year real bonds. Such commitment maintained overtime will enhance the liquidity of the 10-year sector and might prompt the creation of a future contract onreal yields. Such an instrument would of course be welcomed by investors as far as their hedging needsare concerned and would probably in return increase the turnover on the cash market.

A consequence of a more generalised commitment among issuers could be the emergence of a marketfor sovereign signature spreads on real yields in the euro area, with its own constraints, in particular theassessment of the quality of the asset-liability management performed by each issuer. It could also resultin the use by sovereign issuers of inflation swaps as an equivalent of the conventional swap programsannounced for conventional debt.

Figure 8: issues of inflation-linked bonds by France and Italy

0

5,000

10,000

15,000

20,000

25,000

30,000

1998 1999 2000 2001 2002 2003 2004

FranceItaly

The noticeable absence of private issuers on inflation-linked markets could become a cause forconcern. The AMTE survey indicates that there is growing interest for corporate inflation-linkedbonds as evidenced by the issuance of the first corporate inflation-linked bond announced as thisreport was being drafted.

It is a puzzling feature of index-linked markets that there are virtually no corporate issuers of index-linkedproducts in Euro. So far, the non-sovereign payer’s market has been restricted to a very limited number ofagencies, which are benefiting from very strong guarantees.

Market conditions seemed ripe for a healthy start: index-linked bonds, at least in their most commonstructure, give a disproportionately high weight to the final repayment because of its indexation oninflation over the whole life of the bond. Credit investors buying corporate index-linked bonds findthemselves more exposed to a given signature on a given maturity than on an conventional bond; theideal combination for corporate index-linked bonds in terms of market conditions includes therefore lowabsolute levels for spreads, a flat credit curve and a flat breakeven curve – which prevailed in 2004.

There is no consensus as to how the enhancement to asset-liability management that stems from issuingindex-linked bonds should reflect on the rating of the issuer. This question can be particularly acute forPFI schemes, for instance, which are natural candidates for issuing index-linked products. The working



group believes that this crucial question needs to be sorted out before any significant change takes placeon corporate issues of inflation-linked products and would urge rating agencies to examine it.

According to members of the working group, preliminary discussions indicate that credit rating agenciesare comfortable with the concept of using inflation products to hedge risk.

If there are explicit inflation-linked revenues within a specific purpose vehicle (SPV), then inflation-linkedswaps or bonds could theoretically be used to increase the rating. However there are two issues whichadversely effect their development. The first is the alleged poor liquidity of inflation-linked derivativesaccording to rating agencies, so that if a vehicle enters an inflation-linked swap with a counter party thenthe constraint on the swap counterparty will be harsher than for a plain vanilla swap. The second is thebasis risk of inflation: if a SPV has exposure to a domestic inflation and this is hedged with a regionalinflation then the rating agencies would consider the spread between the two inflation rates to assess theeffectiveness of the hedge. Even if the domestic inflation has been in line with the regional inflation, therating agencies may not consider the transaction as a hedge. This is probably the result of poor productknowledge and lack of tools to assess the hedge effectiveness.

Such an obstacle might neither be the only one, nor the most important, and amendments or precisions tothe existing accounting framework IAS39 are probably necessary before further steps are taken, asexamined more closely in a following section. However, survey evidence suggests that there is demandfor corporate inflation-linked products, especially from asset managers.

3.2 Legal and technical impediments are now limited; however accounting ones remain, withrespect in particular to the necessary broadening of the index-linked market.

3.2.1 Homogenisation of index-products has increased and a market standard, at least forbonds, has emerged; on euro-denominated bonds, the homogenisation has consisted inthe choice by sovereign issuers such as Italy and Greece to issue on one single index -the euro HICP excluding tobacco – rather than various domestic indices. More generally,the “Canadian” structure has been validated as the most widely accepted option forinflation-linked bond structures. The resulting improvement in liquidity is of coursefavourable to increasing demand.

The euro-area HICP (harmonised index of consumer prices) excluding tobacco has gainedbenchmark status for intra euro-area index-linked issues.

Most of the inflation needs arise in theory from asset-liability matching which are essentially linked todomestic inflation (project finance, pension funds, saving products, etc…). Ideally each market participantwould like to hold domestic inflation instruments through which it receives domestic inflation. However, forpractical reasons, the need for liquidity is more important. The euro area HICP excluding tobacco seemsto be the best compromise from the point of view of the suppliers of inflation – the inflation payers.

As a result of the need for liquid benchmarks and focus on one index, banks and financial institutionshave become the suppliers of domestic inflation through their structuring desks and are carrying the basisrisk, stripping European into domestic inflation. The development of the index-linked market has thereforedepended on the profitability for banks to carry this basis risk; their incentive to commit to thedevelopment of the market depends on the price of inflation basis risk.



A wider index-linked market involving more domestic indices would probably reduce the price of theinflation basis risk. The role of banks in the future structure of index-linked markets remains a key factorfor the orientation of its development: broader or deeper.

The move towards a standard structure for inflation-linked bonds and the well-understood needfor homogenisation is best illustrated by the case of UK linkers, as described later in part 5.2 ofthis report.

Such a change in the structure of UK index-linked Gilts is not only interesting because it seems topromote the so-called “Canadian” structure as the benchmark structure, in spite of the objectiveadvantages of the previous design (in particular the certainty on the value of the next coupon): it alsoshows how flexible the Canadian structure is, since it can accommodate remaining differences of UKlinkers relative to, for instance, French or US linkers. The first difference is the par guarantee, which is nota feature of UK indexed Gilts but is still compatible with the Canadian design. The other difference is themethodological specificity of the underlying index (RPI) with respect to the European harmonisedconsumer price index, which is not considered an obstacle: the structure of the bond is clearly dissociatedfrom the underlying consumer price index.

The working group underlines however that due to national regulations the inclusion of a par guaranteecan facilitate the purchase of index-linked securities by specific institutional investors (such as Frenchinsurance companies).

3.2.2 Remaining obstacles should however not be minimised and there is room for reforms thatwould facilitate the functioning of the market for index-linked products.

There are still many obstacles to trade index-linked products in the Euro area:- regulatory obstacles,- accounting obstacles,- fiscal obstacles,- technical obstacles, including risk management and asset allocation.

Regulatory obstacles restricting demand remain country-specific. The working group provides a list ofsome of these, which is by no mean exhaustive.

In France for example, the following obstacles can be listed:- Life insurance regulation: the R332-19 article of the “Code des Assurances” prevents life

insurance company to account for corporate index-linked bonds in the same way asgovernment and governmental agencies index-linked bonds. Indeed, our survey of investorsin France clearly underlines the negative impact of the regulation of French insurancecompanies: of 8 surveyed, four French insurance companies specifically mention regulation.Most of the insurance companies surveyed agree that they would increase their participationin the market if the regulatory obstacle was lifted.

- According to a recent change in the financial regulation5, mutual funds cannot borrow morethan 10% of the fund (whereas they can short 100% of the fund). It is a matter of particular

5 Art L.214-4 of the Code des Marchés Financiers



significance for index-linked products as it prevents the implementation of break-evenstrategies.

- French "Caisses de Retraite" are still taxed at 10% of the coupon of French bonds and 24%on non-French bonds. This is a broader subject than purely regarding the inflation market butthat also prevents the euro inflation-linked market from a stronger development.

- The 1958 bill6 forbids the trading of inflation-linked products by French entities, with theexception of INSEE and EUROSTAT ex tobacco indices. Trading of inflation-linked productsdenominated in a foreign currency and submitted to a foreign law are considered exceptionsto this rule. This prevents two French entities to trade inflation derivatives linked to a foreignindex between them, whereas each of them could trade such derivatives with a foreigncounterparty.

In Germany, inflation-linked bonds are currently classified as a "Finanzinnovation". The reason for thisclassification is that the ex-ante income is not known, yet the notional amount is guaranteed. As aconsequence, all capital accretion over the tenure of the bond is subject to a capital gains tax. This is thecase if the bond is held as a single investment or in the framework of a fund.

In Italy, survey results did not point to any significant obstacles preventing investors from entering theindex-linked market; however, some system issues prevented investors from purchasing inflation-linkedbonds in particular on the repo market since until recently, the dirty price calculated by MTS was incorrectand had to be amended manually.

In Spain, Mutual Funds have not been able to use inflation-linked derivative so far. In 2005 will come anew regulation that seems to be less restrictive. Indeed, the CNMV (Spanish regulator for mutual funds)does not yet consider inflation as an acceptable underlying for financial assets. In the case of PensionFunds, the regulator is different although there is speculation about a potential merger between the tworegulators. Nonetheless, pension funds can be active on inflation-linked products.

3.2.3 Significant accounting obstacles remain, as far as the treatment of inflation-linkedproducts by IAS39 is concerned.

The IAS 39 accounting standard is also a barrier for both investors and issuers. The absence of referenceto inflation within IAS39, except within IAS 39 AG33(f) does not allow a clear appreciation of theaccounting treatment of inflation-linked bonds or derivatives, preventing some issuers from accessing thismarket. A lack of clarification of the impact of IAS 39 on inflation-linked bonds holdings, especially as itimpacts potential big holders of such bonds like life insurance companies, has also been a specific barrierto the grow of the inflation-linked market. In order to lift uncertainty, the working group has conducted asurvey amongst major audit firms to seek clarity on the application of IFRS on inflation-linked products,with references to US GAAP for comparison purposes7.

The first goal was to assess whether separation of the inflation component of debt indexed to inflation isrequired under IAS 39. Indeed, IAS 39 AG33(f) states that when a lease host contract is linked to aninflation-related index the embedded derivative is deemed to be clearly and closely related and thusbifurcation is not required (or permitted). However, there is no specific guidance in IAS 39 regardingbifurcation of inflation-linked components from debt host contracts. Still, auditors generally assume thatseparation of the inflation component is not required in that case either.

6 Ordonnance 58-1374 30 Décembre 1958 – art. 79, amended by the law # 98-546 2 July 1998.7 The full survey is available in annex 2



For Euro-denominated issuance, IAS 39 is silent on issues specific to regional inflation and whether, forexample, there should be a different accounting treatment for the issuance of a Euro-denominatedinflation-linked bond by an Italian company if the inflation index was European, Italian or French.

The second goal of this survey was to assess whether, under IAS 39, entities are permitted to designateinflation risk as a hedged risk when the hedged item is a financial asset or liability or when it is a non-financial asset or liability.

Auditors were then asked if one could separate the inflation component from the real rate component in aLibor-based interest rate, in order to hedge only a portion of the Libor rate.

Finally, if inflation was a hedgeable risk, the survey asked whether an inflation option could be designatedas a hedging instrument in its entirety (i.e., designated so as to assess hedge effectiveness based on theintrinsic value and option’s time).

When asked these questions, all four of the major accounting firms have declined to provide feedback "onthe record" regarding the accounting survey. These responses highlights that the main issue is a lack ofclarity on, and clear understanding of, the application of IFRS to inflation-linked instruments. "Off therecord" comments from the accounting firms have also not been consistent in terms of a technicalunderstanding of the issues; they have, however, been consistent in terms of audit firms not wanting topublicly take a position with respect to the issues. The members of the AMTE working group, however,seem to have consistent views regarding the application of IAS 39 to inflation-linked instruments withrespect to the issues covered by the survey.

3.2.4 The working group also underlines remaining system and risk management obstacles,which could be lifted by creating a code of best practice.

Some investors still refrain from trading inflation-linked bonds for operational reasons. There may beback/middle office problems in matching the transaction with the counterparty. However, Bloomberg cancalculate the net amount to pay/receive based on the real price traded. Valuation in portfolios has then tobe adapted for index-linked bonds. The closing price at the end of the day is a “real” price. It has to bemultiplied by the index to get the "nominal" price. Apparently, systems such as MTS and Tradeweb do notyet do this transformation on the clean price, although MTS does it on the dirty price.

Some investors remain puzzled as to how to handle inflation-linked bonds in an asset allocationframework or in terms of risk management. Looking at the risk management of index-linked bonds in aportfolio, the most common question is that of the “beta” to use for the duration calculation – thecoefficient to apply to the duration of an index-linked bond to match a nominal bond. In the past, theFrench CNO recommended the use of 0.5 for the beta, which was consistent with the environment at thattime. The working group is sceptical on the use of such a concept.8

3.3 The working group would recommend a list of measures aimed at facilitating the smoothfunctioning of the index-linked market.

• The working group would expect sovereign issuers to renew their commitment to regularly growthe market. Such a commitment consists partly in a commitment to grow absolute volumes andpartly in a commitment to maintain liquidity on the whole real curve. To satisfy both these aspectsof the commitment, the approach favoured by the French treasury offers an interesting

8 See discussion on beta reporting in part 5.3



compromise, combining the announcement of a minimal share of debt issued in index-linkedsecurities per year and a regular auction schedule. The working group would welcome theextension of such an approach to other issuers of inflation-linked securities. It reminds sovereignissuers that a liquid curve for sovereign bonds is a pre-requisite for the development of corporateindex-linked bonds.

• In the view of the working group, the US precedent would suggest caution in the approach to themarket for short-term inflation hedging. The design of adapted short-term inflation futures isprobably a crucial element and it remains the case that for obvious reasons the market lacksexperience in the valuation of very short-dated inflation-linked bonds. As more and more inflation-linked bonds mature, the issue will become more and more relevant, given the high volatility ofvery short-term inflation and the valuation of seasonality. The working group would certainlysuggest preliminary surveys and increased awareness to this fact.

• Marginal amendments to existing regulation could be performed; in France, the working group would welcome changing the domestic “Code des Assurances” andits restricting R.332-19 & R.332-20 articles. This would allow insurers to purchase inflation-linkedbonds issued by private issuers. In Germany, the working group would recommend an update in the taxation of index-linked bonds.In Spain, it would favour discussing with the Spanish regulator (CNMV) to promote the acceptationof inflation as an acceptable underlying for financial assets.

• More generally, the working group would suggest an adaptation of regulation on repurchasingrules that apply to mutual funds to the specific needs of index-linked bonds, which are often usedtogether with conventional bonds to express views on breakeven inflation in the absence of liquidfutures for real/inflation assets.

• The working group urges for a clarification of the impact of the accounting framework IAS39, whichis the main obstacle to the development of a payer’s side on the corporate index-linked market.Indeed, an important potential obstacle for development of the inflation business is the lack ofinvolvement of corporates in inflation. A major issue is the lack of IAS39/FRS133 transparencyregarding the accounting treatment for inflation hedging instruments. As a result company auditorsand auditing companies can have different interpretations and conclusions about the inflationhedging vehicles. One of the AMTE's role will be (1) to raise these issues to the accounting firmsand regulatory bodies and (2) to educate them on the plain vanilla inflation products and theirapplication for hedging.

4 Standardisation and enhancement

Inflation-markets have strongly developed in the past years in a structural framework that has remainedrelatively homogenous and stable. Issuers have focused on benchmark structures and indices for theirbonds, and inflation-based derivatives have mostly followed. In spite of this rather well ordereddevelopment, some improvements could be suggested; the working group on standardisation andenhancement has looked at ways to foster further standardisation and homogenisation on the Europeaninflation-linked market. Broadly speaking, improvements suggested by the working group affect eitherunderlying consumer price indices, or the structure of inflation-linked bonds.



4.1 Little improvement is needed as far as underlying indices are concerned, given theexperience of statistical institutes, however the working group suggests some clarificationon a limited number of issues

Choice of CPI Indices: so far only two indices are widely used for euro-denominated inflation-linkedbond issuance: the FRF CPI ex-tobacco and the Eurozone HICP ex-tobacco non-revised, while there isone public issue linked to Italian inflation ("Indice dei prezzi al consumo per famiglie di operai e impiegati(FOI) senza tabacchi"). Private placements use more indices, but these are not widely traded after issuedate. Focusing on a limited number of underlying indices has improved the liquidity and transparency ofthe inflation-linked market in its early stage.

Choice of Ex-tobacco indices: following the choices made for bonds, inflation-linked swap marketshave developed using ex-tobacco indices, and all European inflation issuers (France, Italy, Greece) nowuse the European ex-tobacco index. The working group sees no major drawback stemming from the useof ex-tobacco indices in the case of domestic inflation issues. Their generalised use would make differentinflation-linked bond issues more comparable with already existing inflation-linked bonds based on eitherFrench or Euro-zone ex tobacco indices at the cost of a – so far – limited basis risk.

Choice of a non-revisable index: most international indices can be revised in the case of theoccurrence of an error in the calculation of the index. This occurred in September 2000 in the case of USCPI, for instance. It is worth remembering that most indices are revisable as new information is receivedby statistical institutes. For instance, many Euro area countries periodically revise their own calculation.Like US TIPS, all Euro area sovereign inflation-linked bonds are indexed exclusively on the firstpublication of the HICP, regardless of any potential later revision. This means that once the daily indexratios are published for a given month, they will not be change in the case of a revision of the monthlyindex used for the daily calculation. However, the following monthly CPI index published after the revisionof a given month CPI index will incorporate the revised figure. As seen later, ISDA considers in its nowpublished 2005 inflation definitions that this rule applies to all CPI indices.

The working group recommends that data publishers keep records of non-revised indices as wellas revised indices.

Improvement in the index publication: The working group has concentrated on two topics:• All CPI indices are published with one decimal. This is creating some price volatility when the index is

published, reflected mostly in bid/offer spreads. Several bond and swap traders have indicated thatthe publication of the index with two decimals would clearly help them in anticipating the future valueof the index. The working group confirmed with statistical institutes that index methodology would notbe robust enough to allow for more decimals in their publication and would lead to frequent revisionsof the index. Such volatility should be seen as an unavoidable constraint.

• Eurostat publishes every month a news release with updated reading for monthly and year-on-yearchanges in the HICP, including sub-components and special indices. Yet for computational reasonsthe market would require an immediate availability of index numbers rather than index changes, asthey are published for instance in the INSEE press release for the French CPI. The working groupwould welcome the inclusion of index levels in the news release by Eurostat. The group on“promotion and development of the product”, examining the same topic, reached similar conclusions.

Indeed, the press release currently mentions the change in the ex-tobacco index on a year-on-year basis(or % month-on-month), after headline and core inflation releases. According to this group, the index level



itself needs some research and time to be found on Eurostat’s website. The working group wants todiscuss the current dissemination practice of inflation indices with statistical offices and initiate for the ex-tobacco index to be more prominently represented in initial press releases. Bloomberg, Reuters and otherproviders should then publish this index in real time, and ideally publish a consensus survey ahead of therelease. The working group also suggested to liaise with the press to improve communication of “ex-tobacco” index releases used by the linkers markets as opposed to current focus on headline or coreinflation releases (using UK ONS as an example). A detailed strategy is presented in Annex.

4.2 Harmonization in the structure of inflation-linked bonds is gradually improving, yet a majordifference remains for the protection of the principal

Harmonisation in the way the indexation is applied to bonds’ cash flows: Apart from currentinflation-linked Gilts, all sovereign inflation-linked bonds use the “Canadian” structure where indexation isapplied on an interpolated basis using a 3-month lag. The move towards a standard structure for inflation-linked bonds and the well-understood need for homogenisation is best illustrated by the case of UKlinkers.

The indexation lag structure for index-linked Gilts has been included in previous consultations of the UKDMO- most recently in 2001-02. Feedback at the time indicated that the overwhelming majority ofrespondents favoured the so-called Canadian design over the UK 8-month lag design. The DMO alsofavoured the Canadian design as one that would potentially make index-linked issuance more attractiveto international investors.

Views were very mixed on the question of whether and how to implement such a change in design at thattime. Many respondents to the consultation advocated a wholesale conversion programme of old for newdesign Gilts. As indicated in the DMO’s response to Consultation at that time, however, it was generallyacknowledged that such a strategy was likely to be problematic and confusing.

At that time no other changes to the index linked market were under consideration. The publication of theconsultation document on the possible issuance of ultra-long Gilts (including inflation-linked) represents apotential important change for the index-linked market, under which Gilts could come to be issued in anentirely new maturity sector. Furthermore, such new instruments would have a very long residual life, sothat the choice of design would be binding over a much longer horizon than to date.

Another factor influencing the decision is the DMO’s continued wish to diversify the investor base in Gilts.In particular, it is noted that the Canadian design is now more than ever accepted as international bestpractice. The DMO has always felt it important to give sufficient advance notice of any intention to adoptthe three-month lag structure, so as to allow stakeholders time to manage the lead times required for theintroduction of such new instruments.

Harmonisation in full coupon calculation: Coupons on fixed rate bonds are paid on an unadjustedbasis, i.e. if the date for the coupon payment is a non working day, the coupon is effectively paid on alater date yet the investor gets no extra adjustment. By contrast money market instruments are paid on anadjusted basis. Although no specific rule has been set for inflation-linked bonds, coupons on OAT(e)ihave been paid on an unadjusted basis. So far, no coupon on BTPei has been paid on a non-businessday, so the payment rule is not clear for these bonds. Some clarification seems needed: some haveargued that when a coupon is paid on a non working day, the index ratio that applies to the coupon has tobe the index ratio applicable to the next working day – in other words, the coupon is unadjusted but theinflation uplift should be. It is according to some more in line with the very principle of inflation protection.Yet the working group does not agree on this suggestion and recommends paying coupon on an



unadjusted index ratio basis. It is worth remembering that specific index ratios are published for any dayof the month, including Saturdays and Sundays, to facilitate such calculations.

Harmonisation in accrued interest calculation. France was the first euro area inflation-linked bondissuer and Bloomberg had defined a specific calculation type for inflation-linked OAT that followed thespecific French domestic market accrued interest convention. Under this convention French accruedinterest were rounded at 3 decimals. When the Greek inflation-linked government bond was launched,Bloomberg replicated the OATi pricer to apply it to Greek inflation-linked bonds. However, the accruedinterest-rounding rule in Greece does not follow the French accrued interest rounding method. Thesediscrepancies created many unsettled transactions. The working group obtained from Bloomberg aproper calculation of accrued interest.

Principal protection: The more common inflation-linked bond structure guarantees the redemption of theprincipal at par, if, at maturity, the index value is lower than when the bond was issued. However, somesovereign inflation-linked bonds, such as Canada, Japan and UK, do not guarantee a par repayment. Themotivations not to apply such guarantee might differ across countries, creating different risk/return profilesfor inflation-linked bonds.

The working group understands that the absence of a principal guarantee means that investors complyingwith US GAAP or IAS 39 cannot account for these bonds as “held-to-maturity” in their entirety. Instead,the embedded inflation derivatives would have to be separated from the debt host contract. Uponseparation, the embedded inflation derivative would be marked-to-market through earnings and the debthost contract could be designated as held to maturity. This would result in volatility in investor’s earnings.

In addition, this could prevent European investors from purchasing such bonds since domesticregulations applicable to investors, insurance companies, mutual funds or banks, clearly differentiatefixed rate instruments, i.e. bonds, from floating rate instruments, such as stocks. Usually, theseregulations state that a fixed rate instrument must have a fixed maturity date and a fixed maturity priceand their remuneration cannot be directly linked to the results of the issuer9.

Although the European directive10 does not state explicitly that a bond must have a fixed redemptionprice, this requirement seems to be implicit, since to discount cash flows one needs to know them withcertainty.

One can argue that in real terms the principal amount of an inflation-linked bond remains constant,whatever the value of the index that is applied to it. The ECB seems to adopt such a position. In its ruleson monetary eligible assets11, it states page 40: “Tier 1 instrument must be debt instruments having afixed unconditional principal amount…Furthermore, inflation indexed bonds are also eligible”.

However investors’ regulators tend to adopt a very strict attitude and we can anticipate that manyEuropean investors will not be able to buy inflation-linked bonds that do not guarantee the par repayment.This has been clearly indicated in many replies that AMTE received on its investors’ survey.

It is important to point out that in practice the protection of the nominal value of the notional in inflationbonds is low, as these cumulative inflation floors are very far out-of-the money. For them to be in themoney, the inflation to maturity would have to be negative by a value equal to the current break-even plus 9 Under these regulations a money market FRN is treated as a fixed rate instrument.10 Council Directive 91/674/EEC of 19 December 1991 on the annual accounts and consolidated accounts of insuranceundertakings. A similar Directive exits for mutual funds.11 http://www.ecb.int/pub/pdf/other/gendoc2004en.pdf



the accrued inflation since issuance. The value of each floor is less than 1bp up-front for bonds having amaturity lower than 10 years in Euro/FRF and USD. For a short bond like the CADESi06, with five yearsof positive inflation accrued, the annual inflation over the next year would need to be –10% for thecumulative CPI floor to be in the money. For long bonds in Euro/FRF and USD, the floor is worth at most1bp per annum.

Eur_Spot_DIR=115.848

CPI Floor CPI Floor Ref Fwd AnnualisedUpfront Expressed Out-of-ThePrice in bp DIR DIR Moneyness

BTPEI08 0.00% 0 112.607 117.961 -1.40%BTPEI10 0.00% 0 114.96 123.03 -1.28%OATEI12 0.00% 0 108.987 127.935 -2.25%BTPEI14 0.01% -0.1 112.607 133.954 -1.87%OATEI15 0.02% -0.2 114.932 136.581 -1.71%OATEI20 0.05% -0.3 112.623 154.281 -2.09%RFFEI23 0.06% -0.3 111.693 164.779 -2.21%GGBEI25 0.07% -0.3 111.155 175.003 -2.27%OATEI32 0.11% -0.4 111.155 206.082 -2.29%BTPEI35 0.16% -0.6 114.96 220.553 -2.17%

FRF_Spot_DIR=110.471


CADESI06 0.00% 0 100.6 113.165 -10.30%OATI09 0.00% 0 100.174 120.102 -4.41%OATI11 0.00% 0 107.245 125.264 -2.54%CADESI11 0.00% 0 105.253 125.264 -2.85%OATI13 0.00% 0 105.555 130.666 -2.63%CADESI13 0.00% 0 100.174 130.666 -3.29%CNAI16 0.01% -0.1 104.042 139.828 -2.67%CADESI19 0.06% -0.5 109.31 150.449 -2.27%OATI29 0.06% -0.2 100.6 192.632 -2.72%



USD_Spot_DIR=192.4


TII Jan-07 0.00% 0 158.4 202.4 -15.71%TII Jan-08 0.00% 0 161.6 208 -9.89%TII Jan-09 0.00% 0 164 213.5 -7.43%TII Jan-10 0.00% 0 168.2 219.2 -5.82%TII Apr-10 0.00% 0 189.4 220.3 -3.11%TII Jan-11 0.00% 0 174 225.1 -4.63%TII Jan-12 0.00% 0 177.6 231.1 -4.02%TII Jul-12 0.00% 0 179.8 234.6 -3.77%TII Jul-13 0.00% -0.1 183.7 240.9 -3.38%TII Jan-14 0.01% -0.1 184.8 243.9 -3.25%TII Jul-14 0.02% -0.3 188.5 247.8 -3.03%TII Jan-15 0.05% -0.5 190.9 251 -2.86%TII Jan-25 0.23% -1.3 188.5 345.9 -3.13%TII Apr-28 0.09% -0.4 161.7 384.2 -3.84%TII Apr-29 0.11% -0.4 164.4 396.9 -3.75%TII Apr-32 0.21% -0.8 177.5 437.5 -3.41%

Even in Japan, where break-evens are below 1%, a cumulative floor on the 10-year bond is on the orderof 0.50% up-front i.e. 6bp per annum and a cumulative floor on a theoretical 5-year bond would be worth0.60% up-front or 13bp per annum. In the history of G7 since WWII, the biggest period of cumulativedeflation was in Japan between Oct 1997 and Jan 2005 and had Japan issued an 8-year inflation bond in1997, the notional at maturity would have been around 96%.

Clearly, inflation bonds without a cumulative floor may have a slight uncertain notional in nominal terms,but this small uncertainty, which is in fact insignificant in countries outside of Japan, does not warranttreatment of inflation bonds as equity.

As a result, the AMTE working group would like to recommend that regulators, in line with theECB, treat inflation bonds as fixed rate bonds (which they are in real terms) and not treat them asequity.

Similarly, the AMTE working group would encourage the UK and other future European issuers tosystematically embed a floor in their inflation bonds to attract the broadest possible range ofglobal investors.

4.3 The difficult question of the beta in mixed fixed income portfolios

Is there a need for a standard fixed beta factor between nominal and inflation-linked bond price?Funds using inflation-linked bonds as a diversification tool might be requested to report a homogenousmeasure for the elasticity of the value of their investments to changes in yields. Such a reported measureaims at increasing the transparency of the risk associated with holding shares of a diversified fixed-income mutual fund using both conventional and inflation-linked securities. Whilst the elasticity of the



price of conventional bonds is usually measured against changes in nominal yields, the elasticity ofinflation-linked bonds is measured against changes in real yields. Such elasticities, which are by definitioninconsistent, require an adjustment procedure from the real elasticity to the nominal elasticity.

In France, the regulator of financial markets (AMF) requests French mutual funds to report a singleaggregate figure for the price sensitivity of funds mixing nominal bonds and inflation-linked bonds.Although it applies to French funds only, it is a good example of the sort of reporting problem that euroinvestors might run into. At the request of the AMF, in 2000, the CNO, the French bond association, fixedat 50% the modified duration of inflation-linked bonds compared to that of nominal bonds of samematurity. In other words, the elasticity of an inflation-linked bond to nominal yields is conventionallyassumed to be half that of a conventional bond of a similar maturity, so that its price will move by half asmuch for any given change in nominal yields. On average, it was argued, nominal yields can be brokeninto one half which is the real yield, and one half which is the breakeven inflation rate. If this proportion isheld constant over the long run, changes in real yields will on average be half that of nominal yields. This50% ratio, or beta, defined by the French association was based on historical price behaviour of nominaland inflation-linked bonds in various markets, UK, USA, France.

Over the last few years, the price volatility of inflation-linked bond has strongly increased and hassometimes been very close to that of nominal bonds. Many markets participants think that the 50% rule isnow inappropriate to report risk accurately – there is a significant risk of under-reporting the elasticity oflinkers to yield changes -and the CNO has reviewed this coefficient. A specific CNO workshop was set upat the end of 2004 with the participation of mutual funds, insurance companies, and banks. After severalmeetings, the CNO recommended to maintain the 50% beta for the price sensitivity of mixed funds,although it understands that effective betas might diverge from this reporting measure. Itsrecommendation (see annex) opens the door for further suggestions.• For transparent risk reporting purposes, CNO agreed that fund managers could communicate other

indicators of risk, such as the price sensitivity to the change in real rates.• For marketing purposes, CNO agreed that fund managers could communicate a beta corresponding

to the prevailing market conditions.• For regulatory purposes, and for diversified funds only, fund managers may report only one,

aggregate portfolio sensitivity after having attributed a coefficient to the inflation-linked bonds thattakes account of the theoretically lower volatility of real interest rates. In this case, the CNO proposesto maintain a 50% coefficient.

• Funds managing pure inflation-linked portfolio must report the price sensitivity based on a variation ofthe sole real rate.

It is worth noticing that CNO members did not take any view on the market and that the 50% coefficient isseen as a theoretical coefficient based on the current nearly equal split between inflation and real ratewithin nominal rates. Originally, the inclusion of index-linked bonds within a portfolio of fixed rate bondsaimed at decreasing the volatility of the portfolio – it was indeed one of the main reasons to convinceinvestors of the benefits of inflation-linked bonds in terms of efficient frontier. CNO members howeverrecognised that current beta levels are much higher than 50%, but that a longer data sample was neededto assess precisely the beta. The CNO noted that the calculation of a daily beta based on a CPI figurethat changes only once a month (daily inflation references are just interpolation) is not satisfactory. Thereare many different ways of calculating different betas and the CNO did not want to recommend one or theother.

It is clear that the choice of a fixed beta depends on investment strategy and the 50% coefficient is welladapted to long term investors wanting to reduce their exposure against an unexpected rise in inflation, ina very low interest rate environment. It is not certain however that such description perfectly fits the use ofinflation-linked bonds as a diversification instrument in mixed fixed income portfolios.



French investors have also firmly expressed the view that for reporting purposes they would rather stick toa fixed beta. A fixed beta is essential, since investors do not want to change their asset allocationfollowing a change in the regulatory beta. They all recognise that they also report either a different beta orthe real rate sensitivity in their marketing tools.

The new CNO recommendation has been discussed formally by members of the sub-working group. It isworth reminding that:• The default YA (yield analysis) Bloomberg inflation-linked page for all inflation-linked bonds, UK,

USA, France etc. propose a 50% beta.• In the US many fund managers, such as Vanguard Inflation Fund and 59 Wall Street Inflation Fund,

have published marketing documents where they indicate a duration totally different from Macaulayduration using real rate volatility.

• Other members of the working group have expressed their view on the subject: DWS in Germany,“The decision on what Beta factor to apply when comparing an inflation-linked bond with its nominalcounterpart is a rather subjective or biased issue. As you rightfully point out in your paper, there is noclear-cut or "right" beta figure. You make a number of comparisons and I tend to agree with you. It ismuch more a function of what type of investor you are and the trading strategy you pursue. In a way(and I realise I am playing a bit of devil's advocate here) the least biased beta figure one can use, is1. As far as I know, here in Germany there is currently no official recommendation on what beta factoris to be used by mutual funds.

• Hoogovens Pension fund indicates “Time-varying real yield betas do a relatively good job inpredicting real yield changes. However in practice it can be quite tricky to rely on these estimates”.

• The investor survey shows that apart from French accounts, US and Dutch investors seems to favoura fixed beta but do not indicate what a suitable level for such a beta would be.

Given the strong difference of points of view expressed on the beta during working group meetings, theworking group did not reach a satisfactory conclusion for all parts. However, as stated by DWS, with thedevelopment of inflation-linked bond issuance, a standard regulatory treatment among Europeanregulators is recommended. The fact that the CNO has stuck to a beta very different from what the marketcurrently prices can be seen as an interesting starting point for the discussions. And if Europeanregulators agree on a different figure than the current beta recommended by the French bondassociation, the CNO has already expressed that it will favour the use of a standard beta, even if it isdifferent from the 50% currently defined. Indeed, the working group would welcome a homogenous riskreporting method across Europe, however it warns against the over-reliance on the beta as a riskreporting measure.

The working group encourages the reporting of both nominal and real rate exposures for a moretransparent risk reporting.

4.4 Inflation-linked bonds documentation:

Fallback provisions: If an Index is not published on time for a coupon calculation, fallback provisions ofGovernment Bond documentation now appear standardised since the French OAT documentation wasbased on the Canadian one while the Greek documentation was replicating the French one. Italian



fallback documentation follows this standard too. Although current plan12 does not appear as optimal, itwas deemed satisfactory enough and should not be amended since it is now becoming a standard.Finally, since it is highly unlikely that the publication of these indices will cease in the future and given theoutstanding amount of bonds already issued, there is no reason, according to the working group, toamend the current contingency plan.

ISDA has finalised the definitions for inflation derivatives that are now published on its web site:http://www.isda.org/publications/pdf/2005isdainflationdef.pdf

1. ISDA considers all CPI indices as revisable and states: “The first publication or announcement of alevel of such index for a reference month shall be final and conclusive and later revisions to thelevel for such reference month will not be used in any calculations”.

2. In the case of delay of publication of the index, ISDA recommends first to determine the substituteindex pursuant to the terms and conditions of the related bond. If this does not result in asubstitute index or if there is no related bond, ISDA recommends using a formula that applies thelast yearly trend of the CPI to the month which is 12 calendar months prior to the latest publishedlevel of the index. This formula which will mainly apply to derivatives takes into account theseasonality of inflation.

5 Promotion and Development of Products

The working group on promotion and development of product has focused on ways to develop further theinflation-linked market through the promotion of new products derived from bonds and plain vanilladerivatives. It looked at developments which could affect final investors as well as market makers; itsuggests changes on the existing products, which should make them even more transparent, and alsosuggests new products which could complement the existing range.

5.1 Increasing transparency and liquidity of existing products

Benchmark Indices: Dedicated inflation-linked funds will require, as they emerge, a clear way tomeasure their performance. The working group agreed that AMTE should not promote any benchmarkindex but should make everyone aware of the existing indices. Fund managers will choose among thevarious available indices, while derivative users agreed that they would prefer non-proprietary indices.

Electronic systems for bonds and derivatives: The working group plans to initiate improvements in thecoverage of inflation-linked products on standard platforms (e.g. Bloomberg, TradeWeb, MTS and BondVision) and to suggest a minimum standard.

Tradeweb, Bondvision, and MTS all offer basic functionalities. Dealers trading in the MTS cash market forinflation-linked bonds can see both the Blotter and the Settlement Report in real-time. The Blotter showsthe uninflated clean price traded and the Settlement Report shows the uninflated clean price, the inflation-adjusted accrued interest, uninflated nominal amount and the inflation-adjusted settlement amount('Counter Value'). The inflation-adjusted Dirty Price is clear from the Counter Value and the uninflatednominal amount. For dealers trading in the MTS repo market for inflation-linked bonds, the dirty prices(both settlement and term prices) are now the inflation-adjusted ones since September 04.

12 AFT’s inflation-linked OATs contingency plan is to replicate the annual inflation trend for calculating the future indices. Althoughthis does not take into account the seasonality, it was deemed best since it is the same rule as the US and Canadian ones.



Bloomberg is the most powerful and most frequently used information provider. Bond calculation toolsappear accurate:

- there does not appear to be any problem with cash (now that accrued interest on GGB 2025has been corrected),

- YA function is well done, sensitivity analysis is correct with a variable beta, however HS doesnot allow for a variable beta.

- FYH function (number of contracts) is wrong because of the beta, but the beta can bemanually amended.

- YCRV provides a real curve for the two French curves (French and European inflation), anItalian real curve should also come soon.

- Nobody wants to give a seasonality model to Bloomberg, so asset swap calculations are notaccurate (ASW and YAS).

- iSTRIPS are already in Bloomberg (US iSTRIPS have no problem), YA is not working yet onthe BTPei iSTRIPS, but Bloomberg assured it would work when BTPei becomes strippable.

Swap tools are not as developed on Bloomberg side: although Bloomberg has created a generic code fora zero coupon inflation swap, it is impossible to see a curve except by having access to one of thedealers. Some AMTE participants would like to ask Bloomberg to publish an average of dealers quotingon these markets (Euro, France, UKRPI and US) for all tenors. In order to publish an average, it would benecessary to have the support of at least 4 houses (if one does not contribute one day, there will still be atleast 3 other banks to supply quotes). While some dealers did not feel comfortable showing prices to theentire financial community (clients, brokers, and competitors), it was suggested that only the averagewould be published.

These closing prices could be used to calculate P/L but also to develop analytics in Bloomberg (like anominal swap curve). It is easily feasible and should solve many problems traders face these days withinflation derivatives. However, the bank survey showed that most dealers opposed the idea of having acomplete public yield curve.

Breakeven fixing: A complementary solution would be to have a break-even fixing similar to the one thathas already been developed for nominal rates on Reuters ISDAFIX pages. The working group haslaunched a survey of the most active banks on the Euro linkers derivatives market13. The majority of thebanks that replied would be ready to contribute to such initiative (all but 4) for both EUR and FRF swaps.Many would like to have a breakeven fixing on 10 years (all) and 5 years (all but 2) for both swaps, withsome interest for 30-year and 7-year fixings (2/3 of voters each). The structure would be zero coupon,using the monthly index fixing for EUR and the DRI for French. Fixing time would be at 11.00 amFrankfurt in order to match fixing time for EUR CMS rates.

Although using a monthly index is in line with market practice for EUR inflation-linked derivatives, it raisesthe issue of jumps when the reference index changes, rendering structures such as real rate fixings moredifficult to implement on that index.

As no consensus provider appears, the working group proposes to start with all providers withindividual banks then deciding to contribute to some or all of them.

13 See survey and full results in annex 3



5.2 To promote a broader product range, the working group has looked at several possibleinflation future contracts.

Breakeven future: There was a consensus amongst the group that it currently makes little sense to havesuch future.

Future on a basket of real bonds: There was a consensus that such future could become feasible withina reasonable time horizon. As organisation takes time, the group agreed that it might be worth looking atways to formulate rules and try to secure the commitment of an exchange.

HICP fixing future: The working group agreed that there was no action to be taken considering theforthcoming inflation future to be launched by CME in 2005, although some dealers were doubtful aboutthe timing of the launch.

The survey amongst investors showed little appetite for any type of future. The working group stressedthat the bad experience of the original US CPI future market and a failure of a European contract couldgive a bad image to this market and create more difficulties for other future contracts to becomesuccessful.

Strips: There is a simple solution to making coupons fungible. However, the volume needed to be tradedseems large compared to the current size of the bond market. For the moment, AFT has not authorisedthe stripping of OAT(e)is whereas Italy has, although no bond has been stripped yet. The working groupagreed that it would be preferable to wait until the inflation-linked bond market becomes deeper beforedeveloping i-Strips on the European market.

Data dissemination: The working group looked at ways to increase awareness of inflation-linked bondsamongst retail and institutional investors, investment banking analysts and other research analysts,through improving the visibility of bond prices and reference indices in the press. A detailed strategy ispresented in Annex.

The working group proposes to create an AMTE website as a one-stop shop for inflation-linkedinformation (for example information on proprietary and non-proprietary indices)14.

14 Full proposal of architecture is developed in annex 6



6 Recommendations and action plan

The working group recommends the followings:

Increasing transparency and harmonisation:

• The working group would expect sovereign issuers to renew their commitment to regularly growthe market. Such a commitment consists partly in a commitment to grow absolute volumes andpartly in a commitment to maintain liquidity on the whole real curve. To satisfy both these aspectsof the commitment, the approach favoured by the French treasury offers an interestingcompromise, combining the announcement of a minimal share of debt issued in index-linkedsecurities per year and a regular auction schedule. The working group would welcome theextension of such an approach to other issuers of inflation-linked securities. It reminds sovereignissuers that a liquid curve for sovereign bonds is a pre-requisite for the development of corporateindex-linked bonds.

• The working group would encourage the UK and other future European issuers to considerembedding a floor in their inflation bonds to attract the broadest possible range of global investors.Although the premium is not economically very significant, the option of par redemptionguarantees a broader demand. The issue is particularly pressing for the DMO, prior to theissuance of its newly structured index-linked Gilts.

• The working group recommends that data publishers keep records of non-revised indices as wellas revised indices.

• For transparent risk reporting purposes, the working group recommends that fund managerscommunicate the price sensitivity to the change in real rates as an indicator of risk and warnsagainst the over reliance on the beta as a risk reporting measure. It would welcome ahomogenous regulatory risk reporting method across Europe as currently only AMF hasestablished a reporting standard.

Clarifying accounting framework:

• The working group urges for a clarification of the impact of the accounting framework IAS39, whichis the main obstacle to the development of a payer’s side on the corporate index-linked market.Indeed, an important potential obstacle for development of the inflation business is the lack ofinvolvement of corporate in inflation. A major issue is the lack of IAS39/FRS133 transparencyregarding the accounting treatment for inflation hedging instruments. As a result company auditorsand auditing companies can have different interpretations and conclusions about the inflationhedging vehicles. One of AMTE's roles will be (1) to raise these issues to the accounting firms andregulatory bodies and (2) to educate them on the plain vanilla inflation products and theirapplication for hedging.

Amending regulations:

• In France, the working group would welcome changing the domestic “Code des Assurances” andits restricting R.332-19 & R.332-20 articles. This would allow insurers to purchase inflation-linkedbonds issued by private issuers.

• In Germany, the working group would recommend an update in the taxation of index-linked bonds.



• In Spain, it would favour discussing with the Spanish regulator (CNMV) to promote the acceptationof inflation as an acceptable underlying for financial assets.

• More generally, the working group would suggest an adaptation of regulation on repurchasingrules that apply to French mutual funds to the specific needs of index-linked bonds, which areoften used together with conventional bonds to express views on breakeven inflation in theabsence of liquid futures for real/inflation assets.

• The AMTE working group would like to encourage regulators to treat inflation bonds as fixed ratebonds (which they are in real terms) and not treat them as equity. In spite of the uncertainty on thefuture nominal value of cash flows, the real value is known. The working group considers that thefocus should be on the certainty of real cash flows rather than the uncertainty of nominal ones.

Promoting new products:

• In the view of the working group, the US precedent would suggest caution in the approach to themarket for short-term inflation hedging. The design of adapted short-term inflation futures isprobably a crucial element and it remains the case that for obvious reasons the market lacksexperience in the valuation of very short-dated inflation-linked bonds. As more and more inflation-linked bonds mature, the issue will become more and more relevant, given the high volatility ofvery short-term inflation and the valuation of seasonality. The working group would certainlysuggest preliminary surveys and increased awareness to this fact.

• The working group recommends the creation of a daily fixing of inflation breakeven.

In order to successfully implement theses recommendations, the working groups suggests the followingaction plan:

Action for increased awareness

• AMTE to create a web site dedicated to inflation-linked products• AMTE to contact Eurostat to request a publication of the ex-tobacco index in the press release.• AMTE to contact Bloomberg to request the publication of ex-tobacco index together with the headline

index and to publish a consensus survey.

Action for increased demand

• AMTE to contact the French Commission de Contrôles des Assurances to work on amendment of thedomestic “Code des Assurances” and its restricting R.332-19 & R.332-20 articles. This would allowFrench insurers to purchase inflation-linked bonds issued by private issuers,

• AMTE to contact German tax office for an update in the taxation of index-linked bonds that should notbe considered as Finanzinnovation,

• AMTE to discuss with CNMV (the Spanish regulator) to include inflation-linked products in the list offixed income products,

• AMTE to work with French regulators to clarify the legal framework for French entities trading nonFrench or European inflation indices,

• AMTE to contact the Committee of European Securities Regulators (CESR) to have a clearrecommendation on the treatment of inflation-linked investment by fund managers, in order to reportboth nominal and real rate exposure.



Action for payer market

• AMTE to draft a submission to the International Financial Reporting Interpretations Committee(IFRIC) to obtain clarification of the treatment of inflation-linked products within IAS39.

Action for new product development

• AMTE to ask Bloomberg to allow for a user input beta when using the HS function.• Following the commitment of at least 7 banks, AMTE to secure the commitment of several system

providers, such as Reuters, ICAP and Bloomberg, to implement the creation of an inflation break-even.





7 Annex

ANNEX 1. INVESTOR SURVEY AND RESULTS .........................................................................................44

ANNEX 2. AUDITOR SURVEY........................................................................................................................55

ANNEX 3. BANK SURVEY AND RESULTS...................................................................................................59

ANNEX 4. CNO RECOMMENDATION ON INFLATION-LINKED BONDS............................................61

ANNEX 5. PLAN FOR INCREASED AWARENESS OF INFLATION LINKED BONDS ........................63

ANNEX 6. PROPOSED CONTENT FOR AMTE INFLATION-LINKED WEBSITE................................64



Annex 1. Investor Survey and results

1. About You

AMTE - The Euro Debt Market AssociationInflation survey

Investor Type Private Bank

Retail Bank

Bank ALM

Central bank

Insurance company

Pension fund

Hedge Fund

Asset manager: Money market fund

Asset manager: Dedicated European inflation fund

Asset manager: Dedicated Global inflation fund

Asset manager: Diversified fixed income fund

Asset manager: Other

Other

Nationality France

Germany

Greece

Italy

Luxembourg

Netherlands

Spain

Other EMU

UK

Switzerland

Sweden

Denmark

Other Nordic

US

Other Non-EMU

Are you currently managing explicit or implicit inflation-linked liabilities? Yes No

Are you already investing in IL products? Yes No

What is the main purpose of your investment in IL products? ALM

Maturity diversification

Portfolio Diversification

Other

If you are currently managing inflation-linked liabilities, how are you hedging the inflation exposure?

If other, please specify



Inflation size under management

Overall size under management

Currencies

Indices

your management ? your management ?

your investors ? your investors ?

your regulators ? your regulators ?

If yes, please specify (beta, VAR, etc.)

When investing in inflation linked bonds, do you have any additional constraint for reporting to

Do you not invest in inflation linked products because of reporting constraints to

Overall, what are the obstacles to invest (further) in inflation-linked bonds? (E.g. Repo regulation for French mutual funds,...)

The French regulator (AMF) authorizes French mutual funds to report a single aggregate figure for the price sensitivity of funds mixing nominal bonds andinflation-linked bonds. According to a rule defined by the French bond association, they can report their nominal bonds modified duration plus 50% of theirI/L bonds modified duration. The 50% ratio defined by the French association was based on historical price behaviour of nominal and I/L bonds.

Do you think that defining a unique aggregate figure for the price sensitivity of mixed funds is desirable?

Yes No

Do you think that the 50% ratio has to be reviewed (on a regular basis?), since I/L and nominal bond prices have recently been strongly correlated?

Why not?

Yes

No

No opinion

2. Beta



3. Corporate IL bondsWould you buy IL products issued by corporates?

Yes No

Accounting issue

Availability of repo market

Aversion to credit risk

Booking issue

Credit know ledge

Liquidity reasons

Marking issue

Not w illing to mix inflation exposure and credit exposure

Product know ledge

Specif ic Fund / Investment Constraints

Specif ic Industry Regulatory Constaints

Tax issue

Volatility of credit risk

Other

Why not?

If other, please specify.

Yes No

Would you be able to, if this constraint was lifted?



In France, would it increase your participation in the market if the accounting of corporate bonds were aligned to that of SAS bonds? (French Insurance Code, CCA)

Yes No

Issuer risk diversification

Maturity diversification

Portfolio Diversification

Structure diversification (e.g. additive vs. multiplicative)

Yield enhancement

Other

Any size, including private placement Any public issue Benchmark size only

over 250M EUR

over 500M EUR

over 1 billion EUR

Main purpose fur buying it?

If other, please specify.

What minimum issue size would you consider?

What do you consider Benchmark size?



4. Characteristics of your IL investments

The most liquid inflation government bonds (EUR, USD, ...) have a structure with capital indexed to inflation and a floor on the final notional repayment.Some inflation government bonds, such as JPY and UK linkers, do not have principal protection at maturity.

Does this prevent you from investing in these markets? Yes No

Why?

Would you recommend that these countries should adopt the most liquid structure?

Yes No

Would you buy issues without principle protection? Yes No Only in benchmark size

Why not?

Which indices would you consider? Eurozone

Investor's National Index

Any ex-tobacco

Any



5. Other IL products

Is the limited liquidity in the 0-2Y segment of inflation products an obstacle when you invest in inflation products or when you increase your allocation to inflation products?

Yes No

Would you recommend the development of short maturity inflation instruments?

Yes No Not interested

Why not?Hedging/ Risk management

Taking view

Diversify book

Other, please specify

Will you be active on the forthcoming CME future contract on Euro HICP?

Yes No

What other types of future contract, if any, would you like to trade?

Future on a basket of real bonds

Future on bonds breakeven

Future on 10Y inflation swap


What other short term instrument would you consider? Short-term index linked paper

IL Commercial Paper

None


What for?



Section 1 – About you

60 companies answered the survey, Frenchinvestors being more represented, with an

equal proportion of asset managers, insurersand other investors.

Nationality

Denmark 3Finland 5France 17Germany 6Italy 5Netherlands 3Spain 4Sweden 2UK 7US 8

Investor Type

Asset Manager 26Insurance company 14Pension fund 6Bank ALM 2Central bank 1Hedge Fund 1Private Bank 1

Of these 60 surveyed, 33 are currently managingexplicit or implicit inflation-linked liabilities, 51already investing in inflation-linked products.

What is the main purpose ofyour investment in IL products?

Portfolio Diversification 30ALM 10Other 9Maturity diversification 1

Portfolio diversification is the main purpose of theirinvestment in inflation-linked products, followed byALM. Of the other reasons and apart from the

dedicated funds, protection against inflation on along term, distribution to clients, relative value/riskdiversification and opportunistic investment werementioned.

When investing in inflation-linked bonds, doyou have any additional constraint for

reporting to:

Management Investors RegulatorsFrance 4 3 1Spain 3 1Italy 1 1UK 1 1 1US 1 2Germany 1

Out of the 9 investors surveyed that do not investin inflation-linked products, 6 were not investingbecause of reporting constraints to theirmanagement (3 Finnish and 3 German), out ofwhich 2 had additional reporting constraints totheir investors and 2 to their regulators.

Overall, the obstacles listed to invest (further) ininflation-linked bonds were

Regulation 9Liquidity 8Diversification 4Relative Value 4Systems 4Absolute level 3Others 2Tax 1

Some investors also listed the lack of domesticindex as an obstacle.



Section 2 - Beta

Do you think that defining a unique aggregatefigure for the price sensitivity of mixed funds

is desirable?

yesFrance 11Italy 3Netherlands 2Spain 2US 4

Only half of the investor surveyed had an opinionon this question, out of which 22 positive answers:

(and 11 French: 7 insurance companies and 4asset managers).17 of the 22 positive answers (and 9 French) wereof the opinion that the 50% ratio had to bereviewed (on a regular basis), since inflation-linkedand nominal bond prices have recently beenstrongly correlated.Of those who gave a negative answer, someargued that it would make no sense in theircountry, whereas others were mentioning thatsuch figure is not accurate since beta is changing;they would then favour real yield duration.

Section 3 – Corporate inflation-linked bonds

On the question of corporate issuance, 29investors answered that they would buy inflation-linked products issued by corporates.Amongst those not willing to buy, the mostprevalent reason was not to mix inflation andcredit exposure, whereas the French listed specificregulatory constraints. They would however beready to buy such issues if the regulatoryconstraint was lifted.

Not willing to mix inflation exposure and credit exposure 11Aversion to credit risk 4Liquidity reasons 4Specific Fund / Investment Constraints 4Availability of repo market 2Aversion to credit risk 2Specific Industry Regulatory Constaints 2Credit knowledge 2can gain inflation exposure directly using other more liquid and less expensiive altenatives. 1does not like product as such 1no credit exposure within our investment universe 1no spread 1specific fund constraints 1only invest inflation long dated 1

Multiple answers possible

What would be your main purposefor buying this?

Yield enhancement 27Portfolio diversification 10Issuer risk diversification 6Others 6Structure diversification (e.g. additive vs. multiplicative) 2

Multiple answers possible

What minimum issue size would you consider?

Any size, including private placement 7

Any public issue 13Benchmark size 23

What do you consider benchmark size?

over 250m eur 5over 500m eur 25over 1billion eur 10

The issue should have a benchmark size for mostinvestors, i.e. over EUR 500 millions.Moreover, over half of the French investors wouldincrease their participation in the market if theaccounting of corporate bonds were aligned to thatof SAS bonds (French Insurance Code, CCA).



Section 4 - Characteristics of your IL investments

The most liquid inflation government bonds (EUR, USD...) have a structure with capital indexed toinflation and a floor on the final notional repayment. Some inflation government bonds, such as JPY andUK linkers, do not have principal protection at maturity.

21 investors do not invest in these inflation-linkedmarkets because of the absence of principalprotection, mostly for internal rules or forregulatory reasons.40 of the 60 investors surveyed would recommendthat these countries adopt the most liquidstructure.Out of the 35 who could still invest in these issues,21 would buy them, one of the reasons being thatregulatory constraints should be less relevant withIFRS standards implementation.Because of the confusion between the indexation of theprincipal repayment and the par guarantee on theprincipal, the survey results might not be as clear as theworking group would have expected.

Which indices would you consider?

Any 22Any ex-tobacco 4Eurozone 23Investor's national index 8

Out of the 8 willing to buy their national index, only2 do not have such market in existence (the othersbeing from France, the UK or the USA).

Section 5 - Other inflation-linked products

24 investors consider the limited liquidity in the 0-2Y segment of inflation products an obstacle whenthey invest in inflation products or when theyincrease their allocation to inflation products, (vs.34 who answered no).

no yes Total

no 4 1 5

not interested 11 6 17

yes 19 17 36

Total 34 24 58

Would you recommend

the development

of short maturity inflation

instruments?

Is the limited liquidity in the 0-2Y segment of inflation products an

obstacle when you invest in inflation products or when you

increase your allocation to inflation products?

36 investors (out of which 19 who answered no atthe previous question) would recommend thedevelopment of short maturity inflationinstruments.

What for?

Hedging/ Risk management 12

Taking view 24

Diversify book 16

Complete yield curve and thus complete

forward curve1

Of those who were not interested by a short-terminstrument, the main reason given was that suchproduct does not make sense in the short termbecause short-term inflation can be forecastedquite well.8 investors answered that they will be active onthe forthcoming CME future contract on EuroHICP.



Future on a basket of real bonds 11

Future on bonds breakeven 19

Future on 10y inflation swap 11

Other 2

What other types of future contract, if any, would you like to

trade?

On the other type of future contracts, thepreference would be for a future on bondsbreakeven:

Short-term index-linked paper 16

Index-linked commercial paper 5

None 31

What other short term instrument would you consider?

An alternative short-term instrument could be ashort-term index linked paper:

Section 6 - Further Comments

Of the other suggestions made, some investorswould like to have:• bonds linked to local inflation (Dutch or

Spanish for example...),• wider spread of maturity dates,• continued public issuance along the yield

curve that will increase liquidity.Others would like more public information on themarket, with a global screen on Bloomberg and aninflation curve and public closings or fixing at least.It was stressed that the continued development ofthe inflation derivatives market is essential to thegrowth of the overall global inflation-linkedmarketplace.

Investor product education will also facilitategreater product acceptance, particularly strategiesaddressing ALM issues.Integration of the inflation-linked Bonds, namelygovernment bonds, in the broadly adopted indicesrelated to the market capitalization would be thestrongest argument to push more investors in thismarket segment.Finally, according to some investors, an issue bythe German State should trigger an amendment ofthe existing tax law defined as "Finanzinovation" inGermany.



Annex 2. Auditor Survey

The first goal was to assess whether separation of the inflation component of debt indexed to inflation isrequired under IAS 39.

Indeed, IAS 39.10 requires separate accounting for derivative instruments embedded in non-derivativeinstruments when:

- The risks and characteristics of the embedded derivative are not clearly and closely related tothose of the host contract;

- A separate instrument with the same terms as the embedded derivative would meet thedefinition of a derivative; and

- The combined instrument is not already measured at fair value through earnings

While there is no specific guidance in IAS 39 regarding bifurcation of inflation-linked components fromdebt host contracts, IAS 39. AG33(f) states that when a lease host contract is linked to an inflation-relatedindex the embedded derivative is deemed to be clearly and closely related and thus bifurcation is notrequired (or permitted).

Specific to Euro-denominated issuance, a further question is whether Euro-zone inflation-linked issuancewould be treated differently than country-specific inflation-linked issuance’s (i.e., whether a Euro issuancelinked to French inflation would be treated differently than a Euro issuance linked to Euro-zone inflation).On this specific IAS 39 is silent on issues specific to regional currency linked inflation.

As a matter of comparison, US GAAP SFAS No. 133 contains very similar rules to IAS 39 regarding thetreatment of embedded derivatives. SFAS No. 133 however, provides specific guidance on theaccounting for inflation-linked debt instruments. Paragraph 61(b) of SFAS No. 133 states that non-leveraged inflation indexed contracts (debt instruments, capitalised lease obligations, pension obligations,and so forth) would not have the inflation-related embedded derivative separated from the host contract.

US GAAP is silent on issues specific to regional currency linked inflation.

The second goal of this survey was to assess whether entities are permitted to designate inflation risk asa hedged risk when the hedged item is a financial assets or financial liability under IAS 39.

Designating inflation risk as the hedged risk in a hedging relationship does not appear to be prohibited byIAS 39. IAS 39.AG110 requires that the hedge relate to a specific identified and designated risk. IAS39.81 indicates that a financial asset or financial liability may be hedged with respect to the risksassociated with only a portion of its cash flows or fair value.

For comparison purposes, US GAAP SFAS No. 133 contains prescriptive rules regarding the types of riskthat can be designated as hedged. Specifically SFAS No. 133 paragraph 21(f) and 29(h) (for fair valueand cash flow hedges, respectively) state that if the hedged item is a financial asset or financial liability,the designated hedge risk must be:

- The risk of changes in overall fair value (or cash flows);- The risk of changes in fair value (or cash flow) attributable to the designated benchmark

interest rate;- The risk of changes in fair value (or cash flows) attributable to FX rates; or,



- The risk of changes in fair value (or cash flows) attributable to the variability increditworthiness of the obligor.

Our survey was then focussing on whether, under IAS 39, entities are permitted to designate inflation riskas a hedged risk when the hedged item is a non-financial assets or non-financial liability. If it were notpermitted, this application would not be consistent given that inflation risk can be reliably measured in ahedging relationship involving a financial asset or financial liability.

Indeed, IAS 32.82 appears to require that when the hedged item is a non-financial asset or non-financialliability it can be designated as a hedged item only for (a) foreign-currency risks, or (b) in its entirety for allrisks, because of the difficulty of isolating and measuring the appropriate portion of the cash flows or fairvalue changes attributable to specific risks other than foreign currency risks.

US GAAP SFAS No. 133 places constraints on the types of risks that can be designated. Inflation-risk isnot a risk that is specifically permitted as a hedgeable risk under SFAS No. 133 regardless of whetherhedged item is financial or non-financial.

Specific to hedging non –financial assets and non-financial liabilities, SFAS No. 133 restricts the hedgedrisk to (a) changes in the entire fair value of the hedged asset or liability (fair value hedge) or (b) changesin the entire cash flows or functional-currency equivalent cash flows only (cash flow hedge).

However, if inflation risk can be designated as hedged, the question is then over what time horizon canforecast inflation-linked revenues or expenses be designated as hedged under IAS 39.

IAS 39.78 states that, either a single or a group of, highly probable forecast transactions can be designateas a hedged item. IAS 39.88(c) states that a forecast transaction that is hedged must be highly probableand must present an exposure to variations in cash flows that could ultimately affect profit or loss.

IAS 39, IGC F.3.7 suggests that the term “highly probable” indicates a much greater likelihood ofhappening than the term “more likely than not.” IGC F.3.7 states that the following circumstances shouldbe considered in assessing the likelihood that a transaction will occur:

- The frequency of similar past transactions;- The financial and operational ability of the entity to carry out the transaction;- Substantial commitments of resources to a particular activity;- The extent of loss or disruption of operations that could result if the transaction does not

occur;- The likelihood that transactions with substantially different characteristics might be used to

achieve the same business purpose; and- The entity’s business plan.

IGC F.3.7 further indicates that both the length of time until a forecasted transaction is projected to occurand the quantity of the forecasted transaction are considerations in determining probability. That is, themore distant a forecasted transaction is, the less likely it is that the transaction would be consideredprobable and the stronger the evidence that would be needed to support an assertion that it is probable.Additionally, the greater the physical quantity or future value of the forecasted transaction, the less likely itis that that transaction would be considered probable and the stronger the evidence that would berequired to support an assertion that it is probable.



US GAAP SFAS No. 133 paragraph 29(a) states that specifically identified single, or a group of,forecasted transactions is eligible for designation as a hedged item. SFAS 133 paragraph 29(b) statesthat the forecasted transaction must be probable.

SFAS No. 5 defines probable as “the future event or events are likely to occur.” SFAS No. 5 definesreasonably possible as “the chance of the future event or events occurring is more than remote but lessthan likely.” The term probable requires a significantly greater likelihood of occurrence than the phrasemore likely than not.

SFAS No. 133 paragraph 463 states that observable facts and attendant circumstances should support atransaction’s probability. Paragraph 463 of SFAS No. 133 provides identical circumstances forconsideration of the eligibility of forecasted transactions for designation as the hedged item as areprovided in IAS 39 IGC F.3.7; with the exception of consideration of the entity’s business plan.

Finally, can Libor-based interest rates be decomposed into separate inflation and real rate components?If yes, can these components satisfy the conditions of IAS 39.81?

IAS 39.81 states, “If the hedged item is a financial asset or financial liability, it may be a hedged item withrespect to the risks associated with only a portion of its cash flows or fair value...provided thateffectiveness can be measured.”

IAS 39.74 permits the exclusion of the forward differential when hedging foreign exchange risk based onlymovements in the spot foreign exchange rate. That is, under IAS 39.74 a hedged item can still be subjectto variability (in cash flows or fair value) under scenarios where there has been no movement in forwardforeign exchange rate (i.e., movements in spot foreign exchange rates have been offset by interest ratemovements cause the forward foreign exchange rate to remain stable). Similarly, under IAS 39.81 thevariability in the fair value of a bond attributable to movements in the Libor-based interest rate can bedesignated as hedged. That is, the fair value of a bond may remain unchanged despite movements inmarket interest rates if changes in the issuer’s credit spread offsets the movements in market interestrates.

US GAAP SFAS No. 133 places constraints on the types of risks that can be designated. Inflation-risk isnot a risk that is specifically permitted as a hedgeable risk under SFAS No. 133 regardless of whetherhedged item is financial or non-financial.

Unlike IAS 39, SFAS No. 138 paragraph 24 requires that an entity consider all of the contractual cashflows from a hedged item in the assessment of hedge effectiveness. While an entity is permitted to hedgeonly the benchmark interest rate (i.e., the US Libor swap rate), an entity is not permitted to exclude anyportion of the cash flows from the hedged item when assessing hedge effectiveness.

If inflation risk can be designated as hedged, can an inflation option be designated as a hedginginstrument in its entirety (i.e., designated so as to assess hedge effectiveness based on the option’s timeand intrinsic value)?

IAS 39.74 states “A dynamic hedging strategy that assess both the intrinsic value and time value of anoption contract can qualify for hedge accounting”

IAS 39.74 also indicates that a hedging instrument is designated by an entity for a hedging relationship inits entirety. The only exceptions are:



- Separating the intrinsic value and time value of an option contract and designating as thehedging instrument only the change in intrinsic value of an option and excluding change in itstime value and;

- Separating the interest element and the spot price of a forward contract.

IAS 39.AG107 indicates that IAS 39 does not specify a single method for assessing hedge effectiveness.The method an entity adopts for assessing hedge effectiveness depends on its risk managementstrategy. IAS 39.AG112 states, “in assessing effectiveness of a hedge, an entity generally considers thetime value of money.”

IAS 39.96(a) requires that the amount recorded in equity associated with a cash flow hedge be limited tothe lesser of (in absolute amounts):

- The cumulative gain or loss on the hedging instrument from inception of the hedge; and- The cumulative change in fair value (present value) of the expected future cash flows

[emphasis added] on the hedged item from inception of the hedge

Paragraph 4.11 of the IASB’s Insurance Contracts Draft Statement of Principles (DSOP) states,“expected value refers more specifically to one particular estimate, namely the probability-weightedaverage of all cash flows at a given future date...” Applying this definition to IAS 39.96(a) results in thechange in fair value of the cash flows on the hedged item being calculated in a manner that is essentiallyconsistent with the manner in which options are valued.

As a comparison, that applies only where risk is eligible to be hedged in accordance with SFAS No. 133under US GAAP, the Derivatives Implementation Group has provided guidance specific to the issue of thedesignation of the time value component of an option in a qualifying hedging relationship in DIG IssueG20.

Under the approach put forth by the DIG, companies are permitted to assess the effectiveness of a cashflow hedge with an expected cash flow approach that is based on a probability-weighted distribution ofpossible outcomes. Because the expected future cash flows associated with the forecasted transactioncan be determined on a basis that is essentially consistent with the way options are valued, it isunnecessary to exclude the time value of the option from the assessment of hedge effectiveness. Putanother way the DIG permits entities to designate as the hedged item, the cumulative change in expectedfuture cash flows of the hedged item. “Expected cash flow” in FASB Con 7 refers to the sum ofprobability-weighted amounts in a range of possible estimated amounts. Applying this definition to“expected future cash flows” in SFAS No. 133 results in the expected future cash flows of the hedgedtransaction being determined on a basis that is essentially consistent with the manner in which optionsare valued.

In practice entities assess hedge effectiveness under DIG G20 by comparing the total change in fair valueof the actual hedging instrument to the total change in fair value of a hypothetically, perfectly effectivehedging instrument. To the extent that the terms of the actual and hypothetical hedging instrumentsdiverge, hedge ineffectiveness is recognised in earnings



Annex 3. Bank Survey and results

The survey was sent to 19 banks, active on the Euro linkers derivatives market, in order to estimate theappetite for a breakeven inflation fixing and determine its main characteristics

What index would you like to have ?

What breakeven should be determined ? Index(end) / Index(start) vs (1+X%)^T --> fixed rate X to be quoted

What index should be used ? EUR exT FRF

if Monhly, when should we change reference index?

On what Maturity ?

What provider would you recommend to collect and publish data?

What fixing time?

Would you be willing to contribute ?

How would you contribute?

How many decimals should the fixing have?

Further comments

AMTE - The Euro Debt Market Association Inflation - Breakeven Fixing Survey

ICAP Bloomberg

2Y 5Y 7Y 10Y 15Y 20Y 30Y

All from 1Y to 30Y All but 1Y

EUR ex-Tobacco FRF ex-Tobacco

Other :

Acces to fixing page on Bloomberg / Reuters Send fax

Zero Coupon Swap : Other

Yes No

Reuters

Electronic Contribution (mail/file)

Interpolated (DRI)

Monthly Index

Interpolated (DRI)

Monthly Index

11 am Frankfurt Other

The detailed answers to the survey are the followings:17 answered out of 19 that received the questionnaire.All would like to have a fixing on EUR HICP ex tobacco, all but one on FRF CPI ex tobacco, in the form ofa zero coupon swap. The reference index should be DRI for FRF index (11 vs. 5 for monthly index) andthe monthly index for EUR exT (14 vs. 3 for DRI). In the case of a monthly index, the reference indexshould change 2 business days prior to the end of the month.



On the question of maturity, the consensus wasfor a 10 year fixing from all participants, with 5year an additional possibility (14 votes).

On what maturity ?

2Y5Y

7Y10Y

15Y20Y

30YAll

All but 1Y

0 5 10 15

There was however no clear consensus on thename of the provider to collect and publish thedata:What provider would you recommend tocollect and publish data?ICAP 9Reuters 7Bloomberg 7Others 4:

ICAP + Collins Stewart Tullets, Tullets and Cantor

All voters agreed to have a fixing at 11 amFrankfurt time, same times as for CMS fixing.

13 out of the 17 voters would be willing tocontribute, either via access to a page (9), or bysending email (8).

Finally, there was a consensus to have 3decimals for the fixing:

0 2 4 6 8 10

No answer

1

2

3

4

5

Further comments were on the reliability of suchfixing. 2 voters suggested using a similar methodas the one used by ICAP on CMS fixing, havinga minimum of 7 or 10 banks contributing andexcluding the extremes.There was also some concern on theindependence of the fixing provider. To avoid apotential conflict of interest, it was suggested touse two brokers, such as ICAP + Collins StewartTullets or Cantor and publish the results on bothReuters and Bloomberg.An alternative solution would be using anindependent provider willing to do this task on adaily basis.



Annex 4. CNO recommendation on inflation-linked bonds

COMITE DE NORMALISATION OBLIGATAIRE - CNO

Bond Standardisation Committee

An association subject to the Act of 1 July 1901Registered office

56, Rue de Lille - 75007 - PARISTelephone: 01.42.86.87.45

Recommendation on norms for the regulatory disclosure ofinflation-linked bond portfolio sensitivities

In July 2001, and following a request from the COB, the Bond Standardisation Committee (Comité deNormalisation Obligataire, or CNO) recommended a norm for the regulatory disclosure of the pricesensitivity of index-linked bonds: 50% of the price sensitivity of fixed-rate bonds of the same maturity.Over the past few months, and given that the price sensitivity of inflation-linked bonds has been verysimilar to that of nominal bonds, the CNO has examined the case for a review of this norm. Followingconsultation with the various market participants concerned, the CNO has decided to leave the coefficientat 50%. This normative sensitivity permits the aggregation of the sensitivities of diversified portfolios, eventhough on the market the price sensitivity of inflation-linked bonds can be close to, or even greater than,that of nominal bonds.

April 2005: the CNO’s recommendation for the calculation of regulatory sensitivity of portfolioscontaining inflation-linked bonds

• Portfolios containing nominal and index-linked bonds: in their regulatory sensitivitydisclosures, fund managers may report only one, aggregate portfolio sensitivity after havingattributed a coefficient to the inflation-linked bonds that takes account of the theoretically lowervolatility of real interest rates. In this case, the CNO proposes to maintain a 50% coefficient forthe sensitivity of an inflation-linked bond relative to that of a nominal bond of the same maturity.For information purposes, fund managers may also communicate portfolio sensitivity details totheir clients, either by reporting the sensitivity of inflation-linked bonds to the real interest rate, orby reporting a coefficient for these bonds that corresponds to their price volatility compared withthat of nominal bonds. Fund managers choosing the latter course must communicate thereference period and the calculation method used to derive the coefficient.

• Portfolios containing inflation-linked bonds alone: in their regulatory sensitivity disclosures,fund managers must report the sensitivity of the inflation-linked bonds to the real interest rate. Forinformation purposes, fund managers may also communicate to their clients a sensitivitysubjected to a coefficient corresponding to the price volatility of the inflation-linked bonds asobserved on the market relative to that of nominal bonds. In this case, the fund manager mustcommunicate the reference period and the calculation method used to derive the coefficient.

Depending on market developments, the CNO may re-examine the 50% coefficient at a later date.



The justification for the maintenance of a 50% regulatory sensitivity coefficient

Over the past few months, inflation-linked bond prices have often been as volatile as the prices ofnominal bonds of the same maturity. Many fund managers specialised in inflation-linked bonds considerthat they are dealing with a new asset class that could be compared to a new currency. These fundmanagers are active investors, and to them market volatility is primordial. The CNO recommends thatthey report for regulatory purposes the sensitivity to the real interest rate alone.

In contrast, long-term investors include inflation-linked bonds in their nominal bond portfolios in order toreduce portfolio volatility and hedge against any unexpected increase in inflation, in a context ofhistorically low interest rates. In this case, the application of a lower volatility coefficient to index-linkedbonds appears appropriate.

While recognising that inflation-linked bonds constitute a new asset class, the CNO believes that likenominal bonds, inflation-linked bonds belong to the family of euro interest rates. From this point of view, itis reasonable to refer to a beta to calculate the sensitivity of a portfolio containing inflation-linked andnominal bonds.

CNO members are not expressing a view on market interest rates. The 50% coefficient is a theoreticalconstruct based on a roughly equal split between inflation and the real interest rate within nominal interestrates. The Fisher formula shows that in theory at least an inflation-linked bond is less risky than a nominalbond. This is because the expected real interest rate and inflation rate are fixed at the launch of thenominal bond, while an inflation-linked bond will pay the inflation outcome at maturity. It follows that theinclusion of inflation-linked bonds in a fixed-rate portfolio will reduce that portfolio’s volatility.

The CNO is not hostile to the principle of a beta value rather closer to that observed in a durable fashionon the market, but it believes that historical series are not yet long enough to produce a consistentopinion on what that beta should be. Moreover, the calculation of a daily beta based on an inflation figurepublished once a month would not be easy to justify. There are different ways of calculating beta, and atthis stage the CNO does not wish to recommend one method rather than another. The 50% coefficient isa very simple, rudimentary indicator that reflects variations in the market’s coefficient of between 20% and100% over the long term. The present stability of long-term inflation expectations that we may deducefrom inflation breakevens or inflation swaps shows that the market has confidence in the ECB’s currentpolicy. But there is no reason to believe that this policy will never change.

Within the working party, French investors indicated firmly that they wished to retain a fixed 50%coefficient for the purposes of regulatory disclosures to the AMF. They insisted on the necessity ofretaining a fixed beta, because they have no desire to change their asset allocations in the light of aregulatory floating beta. This regulatory coefficient does not prevent fund managers from communicatinganother beta or their sensitivity to the real interest rate in their marketing documents.

In the light of their market development, the CNO and French investors would like Europe-widestandardisation of the regulatory treatment of inflation-linked bonds. The CNO’s adoption of a beta verydifferent from that observed on the market today could be taken as an interesting point of departure forfuture discussions. Were European regulators to agree on a beta, the CNO would favour the use of thatbeta, even if it were different to the 50% currently retained.



Annex 5. Plan for Increased Awareness of Inflation linked Bonds

Objectives

To develop an increased awareness of the inflation segment by press, retail and institutional investors,investment banking analysts and other research analysts

Steps for broader data dissemination

Strategy

The strategy will use multiple channels to highlight inflation-linked bonds including data vendors, pressand research analysts for broader data dissemination on individual bonds as well as for indices

Targets

Target the groups below for publication of individual inflation-linked bond prices, real yields andbreakeven data as well as index data (HICP, bond indices).• Data vendors: Bloomberg, Reuters & Thomson financial• Press

• Papers: L’Agefi, FT, Il Sole, Milano Finanza• TV & Newswires; CNBC and Bloomberg TV, Reuters and Dow Jones Newswires• Periodicals: IFR, IFI, FT Mandate, FOW, Euromoney, Financial News, Global Investor, IP&E &

Global Pensions• Central banks and other economists for research (French and Italian debt agencies, ECB)• Pension fund consultants: Mercer, Fixage, Hewitt, Feri Trust• Organising roundtable discussions on the European linker segment with various trade publications:

IP&E, Euromoney & IFR• Direct mail campaign.



Annex 6. Proposed content for AMTE inflation-linked website

(One stop shop for inflation-linked information)

AMTE website with links to/from treasuries, vendors, inter-dealer and dealer to client markets.

AMTE FAQ (inflation-linked bonds, description, data sources). Participants would be allowed a one-pagefact sheet describing their services

AMTE listing of data sources (Vendors, Newspapers)

Recommended papers to be posted on this site:- Barclays Capital: Global inflation-linked products, A user's guide (January 2004).- ABN AMRO: Mastering inflation-linked products (July 2004).- SG: Using inflation as a portfolio diversification tool (April 2004).- JP Morgan: Investing in inflation-linked bonds (October 2003).

Documents

Inflation- linked products in the Euro area: An AMTE ... final report.pdf · An AMTE working group to standardise, develop and promote the asset class ... Teddy Dewitte (sec gr.2)