Bonds linked to inflation are not a novelty either in India or in the rest of the world. The debilitating effect of inflation on asset prices and the quest to protect the value of investments led to the launch of the first inflation index bonds (IIB) in the UK in 1981.

Since then variants of the instrument were floated, including in the US, Japan, Canada and South Africa. India too has been experimenting with various versions of these bonds over the past decade.

The effectiveness of these bonds in providing a hedge against rising prices and their use in gauging the movement of various other economic metrics has been a popular topic for academic research and publications over the past three decades.

One such paper by Richard H. Clarida of Columbia University – ‘Nominal Exchange Rates and Inflation Indexed Bond (IIB) yields’ – examines the relation between exchange rate of a country, the inflation and the returns on inflation indexed bonds ( http://www.nber.org/papers/w1872 ).

Fair value

Clarida has split the nominal exchange rate (spot rate) into two components, fair value and risk premium. He used the returns on inflation indexed bonds of the home country and the foreign country to arrive at the fair value component of exchange rate.

Since exchange rate is influenced by the prevailing inflation in the two countries, the fundamental value of the exchange rate should be closely linked to the pricing power of the currencies.

He defines fair value as the level of a country’s nominal exchange rate that equates the real return of holding a long maturity home currency inflation indexed bond to the expected real return of holding an inflation indexed bond in a foreign currency.

When the exchange rate is equal to its fair value, expected real returns from holding inflation indexed bonds are the same across countries.

RISK PREMIUM

The difference between the nominal exchange rate and the fair value is the risk premium. The risk premium in an exchange rate is explained as the expected excess return on long maturity inflation indexed bonds in a foreign currency.

The key findings of the author are that 1 per cent rise in the foreign currency risk premium is associated with a 50 basis points rise in inflation indexed bond return differential in favour of the foreign country and 50 basis points appreciation of the foreign currency.

In other words, inflation in either country and movement of the home currency against the external currency are responsible for changes in currencies beyond their fair values.

The author has done a daily analysis on the spot rates of the euro dollar, pound dollar and yen dollar for the period January 2001 to January 2011 and for Japan from December 2004 by splitting them into fair value and risk premium components.

Spot exchange rates, inflation indexed bond yields and monthly consumer price indices for the US, UK, Japan and Euro Zone were used for this study.

The findings are presented in charts of the euro, pound and yen that capture the fair value and the nominal exchange rate.

The gap between the fair value and the nominal exchange rate, that is the risk premium, is easy to decipher from these charts.

Since the period under observation includes the 2008 crash and the subsequent recovery, it is easy to see the impact of shocks on the fair value of a currency as well as the risk premium.

CRISIS AND NORMALCY

For instance, in the euro chart, the nominal exchange rate of euro against the dollar in early 2008 was 1.6. The fair value of the currency at this point was close to 1.4. This period saw the risk premium expand as the dollar appreciated on safe haven purchases in this period.

The fair value of the euro has fluctuated around 1.37 since the 2008 crisis but as the Euro Zone debt crisis unfolded in 2009, the risk premium once again turned favourable towards the dollar resulting in nominal exchange rate spiking towards 1.5 towards the end of 2009.

The author also ran a correlation of the changes in fair value (that is, in turn, dictated by the real return of IIBs in the two countries) and the nominal exchange rate over 60-day periods.

It was observed there were extended periods when the correlation was between 0.3 to 0.4. Also in periods of shocks when risk premiums mounted, the correlation dipped to negative. This shows that fair value and risk premium move in the same direction in most time periods.

It is in crisis periods that the two move in opposing directions.

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