To address inflation risk, many governments issue inflation-indexed bonds (also called inflation-linked bonds or TIPS in the U.S.). These bonds adjust the principal and/or interest payments based on changes in an inflation index, such as the Consumer Price Index (CPI). This ensures that investors receive returns that maintain their purchasing power even when inflation fluctuates.
Inflation-indexed government bonds require daily adjustment of the inflation factor to reflect inflation changes smoothly over time, even though the underlying inflation data (CPI) is published monthly and with a delay (often 3 months). This means daily inflation factors must be interpolated between monthly CPI values that are lagged by three months.
Coupon payment date: Date for which we want to calculate factor
Subtract the lag in months from the given date to get lagged date
Since CPI is only monthly, estimate CPI for every day using linear interpolation.
Using the daily interpolated series, find the CPI corresponding to the lagged date.
Inflation factor are relative to a base CPI date, which is interest accrual date for given bond. Retrieving the CPI at the base date (interpolated if necessary) according to procedure above alows to calculate inflation factor for given coupon payment date for given bond:Inflation Factor=CPI on base dateCPI on lagged date