Wednesday, May 6, 2009

effect of uncertain inflation on debt maturity

Since inflation is generally harder to predict, the longer the period over which the prediction is made, uncertainty about inflation often leads to a reduction in the length of time over which nonindexed agreements are made. Thus the average maturity of debt issued in periods of great inflationary uncertainty is usually less than in more stable times. in some cases this can be mitigated by creative financing. key examples are " floating rate" loans, mortgages, and bonds, which provide medium-to long -term debt at short-term rates. Interest payments are allowed to vary, with each one determined by adding a fixed differential (e.g.,1%)to a specified base, such as the " prime rate" or the yield on a 90-day U.S. Treasury bill in the prior period. If short-term interest rates anticipate inflation reasonably well, such a security is at least a partial substitute for a fully indexed bond.
inflation, if allowed to run rampant, with great uncertainty about the actual level, can threaten the entire structure of a monetary economy, and with it the whole financial sector. On the other hand, it can be controlled within limits, and financial instruments can be designed to avoid some of its serious side-effects.

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