Impact of the introduction of index-linked bonds on a nonindexed bond

Abstract

In 1982 the British government began to issue bonds indexed to the inflation rate. This article investigates the impact of the introduction of this asset on the market for a nonindexed security. The impact is estimated in the context of a model derived from the literature on interest rate determination and, implicitly, from the consumption technology model. As expected, the introduction of the new asset is found to reduce the price of a pre-existing nonindexed asset, as the introduction of a substitute good should do. Further, changes in the prices of indexed bonds are positively related to the price of the nonindexed security.

Acknowledgements

The authors would like to thank Rebecca Davis of the Office for National Statistics UK for sending data not available online and Giorgio Canarella for his comments. All errors or omissions are our own.

Notes

¹Data provided by the National Statistics Information and Library Service, Office for National Statistics, UK. Some data originated with the Bank of England.

²Using an ARMA model to generate inflation forecasts may involve a generated regressor problem. We looked for survey and published forecast data as alternatives, but found nothing suitable.