The Chilean Experience Regarding Completing Markets with Financial Indexation
The general hypothesis that financial indexation to the CPI has been important for the development of the Chilean capital markets is analyzed from several perspectives. The effective maturity shortening of nominal bonds, the likely dollarization of longer term debt and the reduction of average maturities, imply smaller markets or higher expected bankruptcy costs as a direct consequence of not having indexation in countries with moderately high and variable inflation rates. The Chilean market appears as a successful example of financial indexation, with a very large percentage of indexed assets held by investors (between 63 % and 99% - excluding banks and equity investment in the latter measure). The development of an indexed fixed-income market has indirectly impacted the development of others, including the equity market. The distortion in relative returns to debt and equity has also contributed to the development of these markets. Short- and long-term indexed bonds provide distinct, unique and relevant patterns of returns that cannot be replicated in the international markets. This uniqueness is relevant since unexpected indexed bond returns represent "changes in state variables" that significantly impact asset prices, and also since diverse economic sectors would find different "optimal" debt structures (or hedge portfolios), in terms of their relative currency denomination (UF-USD) and maturity. We also find evidence that: i) the Central Bank of Chile's asset composition should include and a small proportion of long-term US government debt and also emerging market equity; ii) it makes little sense for local investors to invest in foreign fixed income as a long-term strategy.
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