Reading the Message from the U.K. Indexed Bond Market: Real Interest Rates, Expected Inflation and the Risk Premium.

The eight-month lag in the indexation of the value of U.K. index-linked gilts, far from being a nuisance, actually makes possible the derivation of estimates of expected inflation from a comparison of the prices of two indexed bonds differing only in their durations, without recourse to any information from the market for conventional gilts. Nominal bond prices can then be used to derive the inflation risk premium. Following this approach, and assuming a stochastic valuation equation to allow for mispricing, the authors fit bond pricing equations to cross-section data for 44 conventional and 11 indexed gilts between 1984 and 1991. They conclude that the real interest rate has more than doubled since 1983. Copyright 1993 by Blackwell Publishers Ltd and The Victoria University of Manchester