20.1 Introduction to Inflation-Indexed Instruments
Inflation-Indexed Instruments is designed to provide investors with a hedge against inflation and can be either in the form of an asset or liability. Banks can invest in inflation-indexed security/bonds or can issue inflation-indexed deposit and advance inflation-indexed loan.
These instruments were created to meet the needs of longer-term investors wanting to insulate their investment principal from erosion due to inflation. The initial paramount and/or interest is indexed to the non-seasonally adjusted Consumer Price Index (CPI) or Whole-sale Price Index (WPI). The index ratio (IR) is determined by dividing the current Index level by the level that applied at the time the security was issued or last re-indexed. If there is a period of deflation, the principal value can be reduced below par at any time between the date of issuance and maturity. However, if at maturity the inflation-adjusted principal amount is below par, the security is redeemed at par.
There are three types of Inflation-Indexed Instruments available in the market:
- Inflation protection to both Principal and Interest
Payments
- The inflation component would be adjusted in the principal by multiplying the principal with IR. At the time of redemption, adjusted principal or the face value, whichever is higher, would be paid.
- The interest rate will be protected against inflation by paying a fixed coupon rate on the principal adjusted against inflation.
- Inflation Protection only to the Principal
- The inflation component would be adjusted in the principal by multiplying the principal with IR. At the time of redemption, adjusted principal or the face value, whichever is higher, would be paid.
- The interest rate will be paid on an unadjusted principal.
- Inflation Protection only to Interest Payments
- The principal will not be adjusted against inflation. The face value will be redeemed at maturity.
- The interest rate will be protected by adjusting the coupon rate against inflation.