Emilio Barone

Index-linked bonds from an academic, market and policy-making standpoint☆

The view put forward in this paper is that the index-linking of long-term public debt today represents a financial instrument that fosters a low average rate of inflation. In particular, bonds that are fully linked to the prices of a representative basket of goods and services permit a reduction in the inflation volatility risk premium, which weighs significantly on the nominal cost of the public debt and, ex post, gives rise to substantial real costs that distort the mechanisms of allocation and distribution and, ultimately, could lead to the debt becoming unsustainable. After re-examining the reasons for the orthodox aversion to index-linking - notably on the part of the monetary authorities of the more stable countries and especially the Bundesbank - the case is put for the leading industrial countries, and notably Italy, to issue index-linked government bonds. By issuing such bonds, the Treasuries of the various countries would send a strong stabilizing signal to the markets because recourse to the inflation tax in the future would no longer be advantageous, reduce the real cost of government borrowing by eliminating the inflation risk premium that currently has to be paid on issues with fixed nominal interest rates, benefit from the positive correlation between the quality of revenue and expenditure, and obtain valuable information on forward inflation rates and the real interest rates implicit in the prices of the bonds. The long-term real interest rate offered by index-linked bonds would act as a sort of lighthouse set up by the monetary authorities to illuminate the path of economic growth and enable operators and markets to coordinate their actions more effectively.

The Information Content of Tips

On January 29th, 1997, an historical date for the U.S. Treasury, the first inflation-indexed Treasury notes, for a nominal value of 7 billion of dollars, have been auctioned. These securities are also called Tips (Treasury inflation-protected securities). Subsequently, the Chicago Board of Trade (CBOT) has proposed two contracts (a futures contract and a futures option) written on Tips. In this paper, after reviewing the characteristics of Tips and CBOT contracts, a pricing model is proposed.

Derivatives and Usury: The Role of Options in Transactions Used to Act in Fraud of the Law

The search for derivative contracts with complex features can also be explained as the market’s attempt to elude the restrictions imposed by the law on money loans. This is an undesirable effect of anti-usury rules. It can be added to the one mentioned by Montesquieu and Adam Smith, who pointed out that usury increases with the severity of the prohibition, since the lender indemnifies himself for the risk he runs of suffering the penalty.In this paper we look at some of the ways in which derivative contracts can be used to circumvent anti-usury provisions and conceal money loans made at exorbitant rates.After examining the simplest cases, we will consider more complex contracts, such as swaps with embedded options, which are often used in dealings between banks and municipalities. Our thesis is that, in all these cases, in order to detect usury, we have to calculate the contracts’ option-adjusted yields.

Capital Requirements, Capital Adequacy and Risk Management

The Basle Committee is seeking to amend the 1988 Accord by introducing a new capital adequacy framework for credit institutions. The proposals, put forward in a consultative paper issued in June 1999 (A New Adequacy Framework), have been submitted for comments to the international banking industry. This consultation has been closed by the end of last March. The proposed future regulatory regime is of paramount importance to all financial institutions as it lays the basis for a level playing field in which to operate.This document aims at contributing to the round of discussions, in order to try and find an optimal solution for all practitioners. After reviewing the main pitfalls of the current Accord, we examine the content of the Basle proposal, focusing attention on the first of the three pillars referred to in the Basle paper, i.e. the Minimum Capital Requirements.We call attention on the need to pursue an integrated approach, taking into account that regulatory issues will affect banking, financial and other institutions on a global scale. Credit risk is in fact just one of the component of the risks undertaken by financial institutions, albeit often the most relevant. The internal ratings-based approach which the Basle Committee is proposing to introduce as an alternative to a modified standard approach should be integrated with the identification of credit spreads applicable to the different categories of counterparts. These credit variables may be treated as analogous to market variables (typically interest rates) in order to quantify the overall market and credit exposure, both in the banking book and trading book. Following this approach it is possible to arrive at an integrated VAR for the calculation of the overall regulatory capital charges. More specifically, the Basle Committee should allow large and complex financial institutions to follow a more advanced approach, based on their own internal models, rather than only on internal ratings.