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POSSIBLE INFLATION-LINKED STRUCTURES Interest Indexed (less inflation protection) Capital Indexed (more inflation protection) Zero-coupon Indexed (most inflation protection) Indexed Annuity MOST DESIRABLE : Capital Indexed Real Coupon, Actual/Actual, Semi Annual (SA) Nominal SA Coupon Payments Original Par * (Index Ratio on Coupon Date) * ( Real Coupon)/2 Current Principal = Indexed to CPI-U NSA At maturity it is Max (100 * CPI-U NSA Index/Ref Index, 100)p%!HG)J%!0 Nominal Price is a function of past inflation not future inflation (3-Month Lagged CPI-U Index on Settlement Date) Index Ratio = ---------------------------------------------------------------------- ( 3-Month Lagged CPI-U Index on Issuance Date) Price/Yield calculation is done in real domain and converted to nominal by the index ratiofCPVO[.[/,!C9F:    H;K<L=//  ` ̙33` 3` 3333f` 999MMM` f` f3` 3>?" dd@+|?" dd@   " @ `"  n?" dd@   @@``PR    @ ` ` p>>0 ;(    Z%xgӳgӳ ?P  T Click to edit Master title style! !:  T&xgӳgӳ ?  RClick to edit Master text styles Second level Third level Fourth level Fifth level!     S   `t&xgӳgӳ ?``  =*   `&xgӳgӳ ?`   ?*   `4'xgӳgӳ ?`   ?*H  033޽h? ? ̙33  ron_standard.pot6 0 @(    T)xjJjJ ?P   x ?*   Tt)xjJjJ ?   x A* p  01 ?+9  x:  T!xgֳgֳ ? @ x RClick to edit Master text styles Second level Third level Fourth level Fifth level!     S  Z!xjJjJ ?P  x ?*   ZCjJjJ ?  x A* H  0޽h9? ? ̙33 0 0( X  H  0޽h9 ? ̙33   ~v (     HT(xg0eg0ef?P0  LTREASURY INFLATION PROTECTED SECURITIES: INFLATION HEDGE OR DEFLATION OPTION,M8<2L   N(xӳӳ?p  D Presented at EFA April 11-13, 2002 Ron D Vari, Ph.D.,CFA Sr. Vice President, Director of Research, State Street Research & Management Adjunct Professor, Graduate School of International Economics and Finance, Brandeis University Lal C. Chugh, Ph.D. Professor, College of Management, University of Massachusetts, Boston822822 EH  0޽h ? ̙33 5-P(    NCgӳgӳ?0  A MOTIVATION ANATOMY OF NOMINAL INTEREST RATES BREAK EVEN IMPLIED INFLATION RATE (BEIIR) VARIOUS INFLATION INDEXED STRUCTURES NOTION OF DIRECT AND INDIRECT DURATIONS WHY TIPS ARE MARKET COMPLETING EXPANDED PERSPECTIVE AND PORTFOLIO IMPLICATIONS  2  ZTCgӳgӳf1?, <AGENDAH  0޽h ? ̙33 qi`( } A~}   NtCgӳgӳ?0P0j  y PROVIDE EXPANDED PERSPECTIVE ON TIPS EXPLAIN DRIVERS OF THE DIFFERENTIAL BETWEEN NOMINAL AND REAL RATES CLARIFY ECONOMIC ENVIRONMENT SUITABLE FOR HOLDING TIPS SUGGEST SEVERAL PORTFOLIO APPLICATIONS AND IMPLICATIONS p%C7! 9! 2  ZCgӳgӳf1?, @ OBJECTIVES  H  0޽h ? ̙33]    p (  2  ZCgӳgӳf1?, W!ANATOMY OF NOMINAL INTEREST RATES""pB  H1?@ @ pB  H1? `P 2  ZTCgӳgӳ1?\L IEXPECTED REAL RATE2  ZCgӳgӳ1?KL IEXPECTED INFLATION2  ZԩCgӳgӳ1?D L A RISK PREMIA  2  ZCgӳgӳ1? \,  UUNEXPECTED REAL RATE PREMIUM2   ZTCgӳgӳ1?` (  UUNEXPECTED INFLATION PREMIUM2   ZCgӳgӳ1?` 8  `(OTHER RISKS PREMIA2   ZtCgӳgӳ1? P`  q9EMBEDDED OPTIONS CONVEXITY BIAS LIQUIDITY, TAXES, CREDIT::pB   H1? ``pB   H1? @ @ pB  H1? PPjB @ B1?P@ jB  B1?P@ ` jB  B1? p p jB  B1?P@ @ ` H  0޽h ? ̙33X (  2  ZԬCgӳgӳf1?, X"BREAK EVEN IMPLIED INFLATION RATE ##^  NԣCgӳgӳ?0 MARKET NOMINAL RATE = MARKET REAL RATE + BEIIR MARKET REAL RATE = EXPECTED REAL + UNEXPECTED REAL PREMIUM + REAL BOND LIQUIDITY PREMIUM - REAL CONVEXITY BIAS - REAL BOND DEFLATION OPTION BEIIR = EXPECTED INFLATION + UNEXPECTED INFLATION + REAL BOND DEFLATION OPTION + (REAL-NOMINAL) CONVEXITY BIAS - REAL BOND LIQUIDITY PREMIMUM  H  0޽h ? ̙33 ( 5 2  ZTCgӳgӳf1?, UNUMERICAL EXAMPLE AS OF 9/20/01    TA Q?1?@" QH  0޽h ? ̙33  B:$(  $ $ # lCgӳgӳ ?@ x 2 $ Zt xgӳgӳf1?, HVARIOUS STRUCTURESH $ 0޽h ? ̙33  h`((  ( ( # lICgӳgӳ ? x H ( 0޽h ? ̙33d P(  Pf P NJCgӳgӳ?0  &AFTER AN EARLY START IT HAS COME TO A HALT CORPORATE ISSUANCE TVA, $300MM, 10-YR FHLB, $200MM, 10YR JP Morgan, $200MM, 15YR Salomon Brother, $400MM, 5YR Toyota Motor Credit, $100MM, 5YR MIPS (Municipal) PROTECTED FROM INFLATION AND TAXES Before-tax yields are very low (CPI-U+1%) ?5,?5+ 2 P ZdICgӳgӳf1?, \&CORPORATE, AGENCY, AND MUNIES ISSUANCE''H P 0޽h ? ̙33 )!,( X , , NLCgӳgӳ?02 &Revisions to CPI Calculation Methodology: Potential Stripping Coupon and principal strips of different bonds not combinable Different bonds different reference index ratios For tax purposes, strips are treated as OID No stripping has yet occurred Trading Practices - Straightforward PSA  Trading Practice Guidelines Price and quotation on real basis Settlement price is adjusted based on settlement index ratio Forward pricing beyond a month is problematic `>%>% 2 , ZdLCgӳgӳf1?, KOTHER RELEVANT ISSUESH , 0޽h ? ̙33 UM(    NLCgӳgӳ?0 9gFLOATING NOMINAL BONDS NEUTRAL TO INFLATION NEUTRAL TO GROWTH CURRENT INFLATION AND GROWH CAN BE REINVESTED AT PREVAILING RATES TIPS NEUTRAL TO INFLATION BET ON LOWER GROWTH INFLATION IS ACCRETED REINVESTMENT RISK TO REAL RATE NOMINAL FIXED RATE BONDS BET ON LOWER INFLATION BET ON LOWER GROWTH REINVESTMENT RISK TO BOTH REAL AND INFLATION COMPONENTS n_cn_c 2  ZMCgӳgӳf1?, d.BEHAVIOR OF FLOATING, TIPS, AND NOMINAL BONDS//H  0޽h ? ̙33V ~( r 2  ZMCgӳgӳf1?( TWHY TIPS ARE MARKET COMPLETING`  c $A a??` aH  0޽h ? ̙33 *(  2  ZTwgӳgӳf1?( \&NOTION OF DIRECT Vs. INDIRECT DURATION''  Nwgӳgӳ?0n  DIRECT PARTIAL DURATION CHANGING OF ONE VARIABLE WHILE HOLDING OTHERS CONSTANT INDIRECT EMPIRICAL OR TOTAL DURATION INCORPORATING INTERDEPEDNECE BETWEEN VARIABLES TIPS DIRECT DURATION TO INFLATION = 0 INDIRECT DURATION TO INFLATION = POSITIVE INFLATION , REAL RATE PRICE DURATION OF OTHER INSTRUMENTS TO INFLATION Q& +"  ]^Q + `  c $A v??  vH  0޽h ? ̙33  aY X(  X2 X Ztxgӳgӳf1?, W!HEDGING TIPS IN NOMINAL PORTFOLIS"" X HA ??!'X $ 00H X 0޽h ? ̙33m 0( r 2  Z4ygӳgӳf1?( ODURATION TO NOMINAL RATES`  c $A l??0 l  Ty1?0 FMOST PORTFOLIOS ARE CONCERNED WITH NOMINAL INTEREST RATE SENSITIVITIES G 2FH  0޽h ? ̙33: @b(  2  ZTzgӳgӳf1?( X"PORTFOLIO PERFORMANCE IMPLICATIONS##`  c $A ??0H   Tz1?@  T ECONOMIC ENVIRONMENT SUITABLE FOR HOLDING TIPS INFLATION RISK: TIPS PROVIDE A HEDGE DEFLATION RISK: TIPS PROVIDE A FLOOR ON PRINCIPAL LOW GROWTH: TIPS APPRECIATE IN PRICE AND PROVIDE INSTANTANEOUS PRICE RETURNSJ0!  1PPH  0޽h ? ̙33 *"P(    N{gӳgӳ? 5 EXPANDED PERSPECTIVE ON TIPS TIPS ARE NOT ONLY HEDGE FOR INFLATION BUT PROVIDE AN OPTION ON DEFLATION DRIVERS OF THE DIFFERENTIAL BETWEEN NOMINAL AND REAL RATES INVESTORS INFLATION EXPECTATIONS EMBEDDED OPTIONS OTHER RISK PREMIA SUCH AS UNEXPEXTED REAL AND INFLATION ECONOMIC ENVIRONMENT SUITABLE FOR HOLDING TIPS INFLATION RISK: TIPS PROVIDE A HEDGE DEFLATION RISK: TIPS PROVIDE A FLOOR ON PRINCIPAL LOW GROWTH: TIPS APPRECIATE IN PRICE AND PROVIDE INSTANTANEOUS PRICE RETURN  J  ;m  /!   !K<n0 2  Zt{gӳgӳf1?( =SUMMARYH  0޽h ? ̙33D 0 T(  T T  H1 ?+9    T  fvgֳgֳ ? @    H T 0޽h9 ? ̙33sxX]l[E>3ίq\tS6iהhFBHNnZi7Zb+eA  <@Ղ HШb,?ɞsfs}K̙33^篟>7%x4H3_X\\tċ%5~F3j$:Z:z5f|_4~r`;VpĊqlQ?Kn7t 3NO `W= ;r/柄#G :O=r*?^ 6da!U)m _0vOzmiDjBZ -1&slW"6 mDڄtf$ i+R'RRbEH=HHۑ>HLuHGڃtR?ҍH@6nA~= kQVy#B-ϚڙC=¢ϯk{G3lz<rtJ4x(r&=-,YkGd'>0si`h~ a% 6*Uzt8}M0+BF'5 ΚXY߉r ),;:!o&MvwK Eos:ONRBd,L֖9 0q8.R=BΝjcmoI=/=2q/:30H U&No&T C(;tH^%t4GzQ̃Ql)'ir&. )VO-J~tJ簩æ~-({\v^%GOsUz0]D`٘<1IvhLʈw~xOz=zowpd}k@c>. ~7`lOJ9Գ0` -9䕨rs Fұ٫3׾$Y!fPzWMl\ӟ |TRݸTRZJ%#,?N 8}Bg@1 ~H$$$$$Rȧ+L) 2 d: @AfDAb q9 sA*@*ATTYRR R$Rd1Hf DQZ ".n \r)*^ } k@ E<(|`,v8d[9)0c [D*)=9y\OhS'GXʴLUWŒ/oc;ױλ{ 6kWB;ٍP6Í*|ۏu}~;>+ ψ^u_8imǾ_Nc;>8Wc0:@gӾ\>kÛwvߺ99rt獻O&hu 5|̩ܺkf^'EgX&Ԟ?կ\~ [0 ͢60~/!݌Q>r7_?sKt;a+kee;[h\G?Plwʑi?TYx`FGG;8>ָV5n~D_{3x; N_ }@{l+fE G'aP:P`T{O:&AO.I`/ \X ˋi LvD軘!>{Gr1s֫:}; zkN_逽| *{H͖SwN]媙k3sύϩ3'zن*#\Aϴ_ӟr%Iu H#k QrX%QdP% 6xmr7j8ըjճ+94\j/^URd[4jPC?C9C3VX@(؟rD6&sٷLr-Ⱦ{1ʵ|)"$#X-`ON"2+SX)(}Z6Tq?牳BEvӉ;,xM|~<Ǜ GsAW Ypb8\JQbV\b'gy-ʂǘkԸ\cEY{}%p[?r'ɾ |7j9n?1~3EYp}mgY_qD֗ ,63AUc _E:#'tf%`ė <2/  fxJpbNb"&Msci6 1˾ivc4{뭷XP5;6(C(Clhh/{衇Xc#A 6^6CgM {> Иo0 x#9^,xIg.B>rP.XoQ`"3 4"RqYȬd1"[,H"I iFimE$B]ozg 5 /7XF^ -B+۬PB)yFpieFoepq)T6W8:)` HJh(%fgwOO?`n%y)]51#c[][BRsxp-L`nHc@;ǒ["]=)ѵ;ۆoVXM7oAK=ۇFdžGS`vݼSf ~ztEcU}ўk{{=}+{;w.?gm{}к) @hG_5}].﹢o]*4jf,OpeapWA-4 ̓ gZ|oqIɬ&$G5+_|gS36H| o:`NxĻzEVlgZ_xƄ^Mk~0~ۗ%B:?e<2nt}L{/XD('B5.FPu֨Zl3|o7Z'j˼-˭vq^^enkh|NA^sgӝڡ8/=}3_n]=񏁋gc }'j'mYfwO? h<,AMLDG!/&8@Wڑrίf 7ۨFkC N|wo̪`%ڨ>=ĈCC2-q;ذ-[@Xnx]D|[۶/;^;fC :Z(aܚV*)I߫Y l>p^z`+ꂜz P4lRčPhzr5 |oҲkx)]kdrDs]<(o? # lz19Og]9A{P!1Z4do@-(ȴZ "O  +mEL! %GEq]ԍc bP.a/ǴG^X;=n˳!,V&[JXZwJ kRS >15O'%Hp-]<w'=5夭` g~5SS:uA5R]`3))EibdK4OluӰfaeW f l`n i_:ƵuoSb@)7jmñq -.0oa~RS* [ BGXY4ðB:TR9QT+*U( + Mԥ~[et2zFetkZ(&9O7O\3ZWn)밅ly& R5:"3RR|H|c4FaTsɜ[%g4tV *[¢ڑ7SgibZih:@n76sr?+)z4ȧ *xV0T12LK> \#bU9;S[=/ Zl&V\FU*4ek./^8z 4y}gsYy!+!?/OrUh\B+)w~ֱ<_gM"̇0sx~wZ 8YՂdW.U"!7N<ɳ@7a7AbG?=ycԥ:D8|Xw~ [#Pu.sp dhtLtóp;&c;~s "3Lĉl媦c,7džIDŽc蘜pL6 \x!VH7lVqb;8nA-5L+3e>jbb {Ll;V.f1rlCpVe{Secy}\4 u?zi"h0՗'{a[3<L q4! 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DrakeJC:\Program Files\MSOFFICE\Templates\Presentation Designs\ron_standard.potn Ron D'VariF115Microsoft PowerPointFIC@PP^@71fm@m@׊MG oM  & &&#TNPP0D x & TNPP &&TNPP    33--- !---&y&8 wwgw8 - Times New RomanwgwO  - . 2 e1 .f--- !J8H--- Times New Romanwgw8 - .C2 Q(TREASURY INFLATION PROTECTED SECURITIES:     . .<2 t#INFLATION HEDGE OR DEFLATION OPTION    .--(-- Times New RomanwgwO  - .2  Presented at    .Times New Romanwgw8 - . 2 -EFA.Times New RomanwgwO  - .!2 EApril 11-13, 2002    .Times New Romanwgw8 - .'2 {gRon DVari, Ph.D.,CFA    .Times New RomanwgwO  - .y2 LSr. Vice President, Director of Research, State Street Research & Management                  . .2 M^Adjunct Professor, Graduate School of International Economics and Finance, Brandeis University                      .Times New Romanwgw8 - .$2 wLal C. 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