The British index-linked gilt market: A financial analysis
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Index-linked gilts are gilts whose principal and coupon payments are fully linked to the Retail Prices Index (RPI), the British equivalent of U.S. Consumer Price Index, with an eight-month lag. The indexation is lagged for two reasons. In order for traders to calculate the accmed interest during the six-month interval between the two coupon payment dates, the exact amount of the next coupon payment must be Icnown, which therefore needs to be indexed to the RPI six months before. The other two months are required for the lag between measurement and announcement of the RPI. Because of the lagged indexation, the RPI eight months prior to the issuance date is used as the base index. The first coupon payment is equal to the promised semi-annual coupon payment multiplied by the ratio of the RPI two months before issuance to the base index. In other words, the first coupon payment is scaled up by the inflation rate, as measured by the rate of change of RPI, of the six-month period from the base month. The inflation adjustment factor for the second coupon payment is the inflation rate of the twelve-month period from the base month. All the following coupons are indexed to the RPI in a similar fashion. The last coupon and the redemption value at maturity date will be adjusted by the ratio of the RPI eight months before maturity to the base index.