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Prepared by Rodolfo Luzio (Ext. 3-8327).
The trade-off between broadening financial markets and the risk of fragmenting market liquidity is an issue that has received significant attention in countries with falling or low debt stocks, such as Australia or Canada. See, for instance, Bank of Canada (2003).
Most recently, the U.S. Treasury announced an aggressive expansion of its IL bond program with expected net new issuance of about US$60–70 billion a year in the next couple of years, about a third of the current total market capitalization.
See Bridgewater (2002) for an efficient frontier analysis showing the degree to which IL bonds merit inclusion and that they tend to displace nominal bonds with a typical portfolio. Bodie (1990) shows how the introduction of IL bonds can improve portfolio efficiency, and why these instruments are the only hedge against long-run inflation risk.
This is in stark contrast to most other sovereign IL bond markets, which, despite their rapid growth, still represent a small share of the total sovereign debt markets.
Another important innovation included the stripping of coupons allowing the development of zerocoupon instruments.
Pension payments are tied to the UF and the minimum pension guarantee is also linked to the UF.
The econometric analysis below does not take into account the pricing implications of these minor structural differences.
Risk America.com kindly provided the UF yield data for Chile. The data for other countries was obtained from Barclays Capital.
The theoretical basis for the empirical evidence of the predictive power of the yield curve refers mostly to real yields rather than nominal yields. For instance, Plosser and Rouwenhorts (1994) use real business cycle models to explain the relationship between the term structure and real activity.
Following the nominalization of the monetary policy target, short-term UF yields moved closely with inflation as short-term nominal interest rates were anchored around the monetary policy target.
Indeed, breakeven inflation, measured as the difference between nominal and real yields of central bank paper, has been consistently below inflation expectation measure of the Central Bank of Chile’s survey of market participants and the Bank’s inflation projections.