The UK government may change the measure of inflation which will have a significant effect on the inflation linker market which is currently 338 billion sterling. This is a special risk not found in commodity markets which is governments may change the rules of the game. The change in inflation measurement will reduce the liabilities of the government but at the expense of those who have bought inflation products. Some now say that this could have a 40% impact on the value of linkers.
There are two major inflation indices in the UK. The RPI (retail price index) which is calculated by using an arithmetic mean and the CPI (consumer price index) which uses a geometric mean. The CPI allows for the substitution of cheaper goods and will be lower than the RPI. The difference now is 50 bp (3.5% versus 3.0%). There is a UK government committee proposal that will switch the RPI calculation so that it is closer to the CPI. There are "Materially detrimental" clause in the RPI linkers, but there may be a disagreement between Treasury and the BOE on what it means to have a material change in the bonds.
The cost is high for these products. Yields are currently negative in the UK. The question is whether futures can serve as a better alternative for inflation protection. You get liquidity with futures, but you do have basis risk between the commodity behavior and the inflation index. Commodities as an alternative inflation protection improves if there are going to be changes in the construction of inflation indices which effect swap and bondholders.
There are two major inflation indices in the UK. The RPI (retail price index) which is calculated by using an arithmetic mean and the CPI (consumer price index) which uses a geometric mean. The CPI allows for the substitution of cheaper goods and will be lower than the RPI. The difference now is 50 bp (3.5% versus 3.0%). There is a UK government committee proposal that will switch the RPI calculation so that it is closer to the CPI. There are "Materially detrimental" clause in the RPI linkers, but there may be a disagreement between Treasury and the BOE on what it means to have a material change in the bonds.
The cost is high for these products. Yields are currently negative in the UK. The question is whether futures can serve as a better alternative for inflation protection. You get liquidity with futures, but you do have basis risk between the commodity behavior and the inflation index. Commodities as an alternative inflation protection improves if there are going to be changes in the construction of inflation indices which effect swap and bondholders.
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