2. INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE Presented At IAFE 1997 Annual Conference Ron D’Vari, Ph.D.

3. TIPS, IAFE 1997, Ron D'Vari2 ANATOMY OF NOMINAL INTEREST RATES FACTORS INFLENCING INFLATION EXPECTATIONS REVIEW OF TIPS AND CIPS (STRUCTURE, HISTORY,ETC.) REAL VS NOMINAL RISK MEASURES TIPS VALUATION AND BREAKEVEN ANALYSIS US CPI-URN-NSA HISTORICAL PERFORMANCE TACTICAL VS STRATEGIC USE OF TIPS/CIPS AGENDA

4. TIPS, IAFE 1997, Ron D'Vari3 ANATOMY OF NOMINAL INTEREST RATES EXPECTED REAL RATE EXPECTED INFLATION RISK PREMIA UNEXPECTED REAL RATE PREMIUM UNEXPECTED INFLATION PREMIUM OTHER RISKS’ PREMIA LIQUIDITY CREDIT ETC

5. TIPS, IAFE 1997, Ron D'Vari4 FACTORS INFLUENCING INFALTION EXPECTATIONS ECONOMIC GROWTH TRADE POLICIES/ BARRIERS MONETARY & FISCAL POLICIES LABOR MARKETS GOODS MARKETS DOMESTIC INTERNATIONAL GLOBAL COMPETITION CURRENCY REGIMES/POLICIES PRODUCTIVITY GROWTH CAPITAL GOODS INVESTMENT

6. TIPS, IAFE 1997, Ron D'Vari5 HIGHER CONFIDENCE ON US MONETARY AND FISCAL POLICIES  Global emulation of US economic policies STRONG US DOLLAR (LOW IMPORTED INFLATION)  Southeast Asia new free currency regime  Yen’s further weakening PRODUCTIVITY IMPROVEMENTS  Computer technology payoffs  Investments in capital equipment GLOBAL EXCESS CAPACITY LOWER TRADE BARRIERS  Increased global competition  Low pricing power RISKS: Low unemployment, increased union power, inflated financial asset prices CURRENT DRIVERS OF LOW INFLATION

7. TIPS, IAFE 1997, Ron D'Vari6 POSSIBLE INFLATION-LINKED STRUCTURES –Interest Indexed (less inflation protection) –Capital Indexed (more inflation protection) –Zero-coupon Indexed (most inflation protection) –Indexed Annuity MOST DESIRABLE : Capital Indexed –3.375% Real Coupon, Actual/Actual, Semia Annual (SA) –Nominal SA Coupon Payaouts Original Par Amount * (Index Ratio on Coupon Date) * ( 3.375%)/2 –Current Principal = Indexed to CPI (accretes with CPI-U) VARIOUS STRUCTURES

8. TIPS, IAFE 1997, Ron D'Vari7 Nominal Price is a function of past inflation not future inflation (3-Month Lagged CPI-U Index on Settlement Date) Index Ratio = ---------------------------------------------------------------------- ( 3-Month Lagged CPI-U Index on Issuance Date) Price/Yield calulation is done in real domain and converted to nominal by the index ratio

9. TIPS, IAFE 1997, Ron D'Vari8 Revisions to CPI Calculation Methodology - Uncertain Can be lower as much as 0.5%/Year More an issue with 10- and 30-years than 5-year Stripping Has To Be Further Clarified  Coupon and principal strips of different bonds not combinable  Different bonds different refernce index ratios  For tax purposes, strips will be treated as OID  No stripping has yet occured Trading Practices - Straightforward  PSA a "Trading Practice Guidelines  Price and quotation on real basis  Settlement price is adjusted based on settlement index ratio  Forward pricing beyond a month is problamatic OTHER ISSUES

10. TIPS, IAFE 1997, Ron D'Vari9 Forward Pricing Analysis Cost of Carry Analysis Buy/Sell Back Repo Analysis Inflation Indexed Bond Futures CPI-U Swap Analysis CPI-U Linked Options DERIVATIVES PRICING

11. TIPS, IAFE 1997, Ron D'Vari10 TIPS’ BASIC STRUCTURE  Principal adjusted daily based on 3-m lagged index ratio  Index = NSA CPI-U (all items for all urban consumers) Nov. 96 ==> Feb 1, 97 and Dec. 96 ==> March 1, 97 Linearly interpolated in between  Principal adjustments are not paid out periodically (treated like a zero - compounds daily)  Semi-annual coupon (real) based on adjusted principal  100% of Original Principal is Guaranteed at Maturity Prin. At Maturity = Max [Orig. Prin., Orig. Prin. x Index Ratio at Mat.]  CAN BE STRIPPED DRAWBACKS OF US TIPS STRUCTURE  Principal Appreciation Taxed Annually  Can lead to negative nominal cash flows (high inflation)  Less attractive for taxable entities such as retail investors US TIPS: A BRIEF HISTORY

12. TIPS, IAFE 1997, Ron D'Vari11 ISSUANCE  QUARTERLY SINGLE-PRICE AUCTIONS 10YR: 1/29/97 for $7.6B and 4/08/97 for $8.4B (retap) 5YR: 7/09/97 for $8.4B  INITIAL AUCTION WAS VERY SUCCESSFUL (Bid/Cover of 5.2 at Real Yield of 3.44%)  LACKLUSTER RETAP OF 10-YR AND 5-YR AUCTIONS  US TREASURY HAS EXPRESSED ITS COMMITMENT TO THE TIPS PROGRAM  AS OF 9/19 TIPS CONSTITUTED 0.7% OF TREASURY INDEX AND 0.48% OF AGGREGATE INDEX  30-YR TO BE ISSUED IN 1998 US TIPS: A BRIEF HISTORY

13. TIPS, IAFE 1997, Ron D'Vari12 US TIPS: AUCTION HISTORY LIQUIDITY  HAS BEEN INLINE WITH EXPECTATION SO FAR  EXPECTED TO INCREASE WITH ISSUANCE  IN FUTURE YEARS CAN BE AS MUCH AS 30% OF NEW COUPON ISSUANCE  WILL SOON SURPASS ANY OTHER FOREIGN I/L MARKETS

14. TIPS, IAFE 1997, Ron D'Vari13 CPI-URN SEASONAL EFFECT

15. TIPS, IAFE 1997, Ron D'Vari14 CPI-URN-NSA TREND

16. TIPS, IAFE 1997, Ron D'Vari15 20 YR=4.95%, 10-YR=3.54%, 5-YR=2.68%, 3-YR=2.57% 1-YR=2.23% CPI-U NSA PAST PERFORMANCE

17. TIPS, IAFE 1997, Ron D'Vari16 SOME CORPORATE ISSUANCE  TVA, $300MM, 10-YR  FHLB, $200MM, 10YR  JP Morgan, $200MM, 15YR  Salomon Brother, $400MM, 5YR  Toyota Motor Credit, $100MM, 5YR HAS SLOWED SIGNIFICANTLY RELATED ISSUES Advantages and Disadvantages From Issuer Perspective - Diverse motivation for issuance Alternative to Short Term or Long Term Debt? Hedged vs. Unhedged Issuance VALUATION ISSUES Total Inflation Protection vs. Non-Accretion Relative Value Analysis for Different Structures MIPS (Munis) PROTECTED FROM INFLATION AND TAXES Before-tax yields are very low (CPI+1%) Only riskless asset? CORPORATE, AGENCY, AND MUNIES ISSUANCE

18. TIPS, IAFE 1997, Ron D'Vari17 REAL VS NOMINAL RISK MEASURES

19. TIPS, IAFE 1997, Ron D'Vari18 NOMINAL HEDGES CAN BE IMPERFECT

20. TIPS, IAFE 1997, Ron D'Vari19 5Yr TIP’S RISK

21. TIPS, IAFE 1997, Ron D'Vari20 10Yr TIP’S RISK

22. TIPS, IAFE 1997, Ron D'Vari21 5Yr Vs 10Yr TIPS’ Yield History

23. TIPS, IAFE 1997, Ron D'Vari22 5Yr Vs 10Yr TIPS’ Historical Yield Spreads

24. TIPS, IAFE 1997, Ron D'Vari23 5Yr Vs 10Yr TIPS’ Price Regression

25. TIPS, IAFE 1997, Ron D'Vari24 5Yr Vs 10Yr TIPS’ Yield Regression

26. TIPS, IAFE 1997, Ron D'Vari25 5-YR TIPS VALUATION

27. TIPS, IAFE 1997, Ron D'Vari26 5-YR TIPS VALUATION

28. TIPS, IAFE 1997, Ron D'Vari27 10-YR TIPS VALUATION

29. TIPS, IAFE 1997, Ron D'Vari28 10-YR TIPS DURATION BASED ON SCENARIO ANALYSIS

30. TIPS, IAFE 1997, Ron D'Vari29 STRATEGIC  DIVERSIFICATION REDUCED RISK HIGHER SHARP RATIO  REDUCE RELATIVE RISK TIPS INCLUDED IN LEHMAN AGGREGATE INDEX  LIABILITIES INDEXED TO INFLATION TACTICAL  ENHANCE RELATIVE PERFORMANCE DUE TO UNANTICIPATED INFLATION  BUY INTEREST RATE PROTECTION CHEAP PORTFOLIO USE

31. TIPS, IAFE 1997, Ron D'Vari30 Piet M.A. Eichholtz, ET. AL, Journal of Fixed Income, December of 1993  UK: January 1983 to December 1992  Israel: January 1984 through May 1992  Used Cash, Nominal and IL Bonds/Bills and Equity  Considered both low and high levels of risk tolerance