New Update on PPI Model for Inflation Book

Dear all,

Attached is Anjam's reasoning and final version of the UK PPI PLLU model.

The UK Inflation Book's main exposure is to two PPI indexes - the PLLU and
the DZCV through year 2010. Both are PPI Output indexes with very comparable
baskets. The only significant difference between the two is the presence of
energy in the PLLU (7.6%). The model in use escalates the two indexes by the
same factors. However, with the energy price fluctuations in recent years
different models for the two indexes would reflect better the nature of their
drivers. Anjam concentrated on the PLLU index first and he will shortly
construct one for the DZCV based on the same methodology, but without the
Brent Crude curve.

The new model achieves the two main objectives of the PPI curve: it is
significantly more robust and stable than the existing one, and it is
considerably less sensitive to the input coefficients. This will result in us
having more confidence in our monthly P&L as well as less fluctuations.

Best regards,

Martina
x34327

Anjam Ahmad
10/03/2000 11:59
To: Martina Angelova/LON/ECT@ECT
cc:

Subject: New Update on PPI Model for Inflation Book

Dear all,

I followed up on the suggestions of happening babe at the conference call as
follows:-

1) USE LESS DATA

Unfortunately, kicking out only 1990 makes the overall equation a lot less
robust, in fact dramatically so, and so eliminates the possibility of using
less data. The model tested was the RPI(month+15) & Deviations from
long-term average for Brent Crude. The r-squared and F-statistic collapsed
by eliminating the first 12 months of data.

2) DEVIATIONS IN CRUDE VARIABLE

Shifting the crude explanatory variable backwards and forward by 3 and 6
months did not alter the model goodness-of-fit parameters dramatically and so
my suggestion is that we stick with the following model:

PLLU[t] = a.RPI[t] + b.RPI[t+15] + c.BrentCrudeDeviations[t] + Constant

3) TESTING MODEL WITH SINE WAVE

To gauge the response of the model to wildly-varying RPI forward curve, a
sine wave of period 3 years for RPI was input into the PPI model. The result
was as expected; PPI pre-empts the moves in RPI by about 8 months. The
magnitude of the oscillations is also reduced. This shows that if we had
more detail in our RPI forward curve, then the PPI model would reflect those
peaks and humps adequately.

CONCLUSION

I therefore propose that we use the model that incorporates RPI, RPI[t+15]
and deviations of Brent Crude from long-term average. The new model is
plotted below in burgundy and can be compared to the old PPI which is
depicted in blue.

Please note that all this analysis only applies to PLLU, and that a separate
study will be needed for the DZCV PPI index.

Regards,

Anjam
x35383

---------------------- Forwarded by Anjam Ahmad/LON/ECT on 09/03/2000 16:52
---------------------------

Anjam Ahmad
08/03/2000 14:03
To: Martina Angelova/LON/ECT@ECT, Harry Arora/HOU/ECT@ECT, Maureen
Raymond/HOU/ECT@ECT, Zimin Lu/HOU/ECT@ECT, Farouk Lalji/HOU/ECT@ECT
cc: Trena McFarland/LON/ECT@ECT, Dale Surbey/LON/ECT@ECT, Stinson
Gibner/HOU/ECT@ECT, Vince J Kaminski/HOU/ECT@ECT, Leandro
Ibasco/Corp/Enron@Enron

Subject: Update on PPI Model for Inflation Book

Dear all,

We thought it might be useful to incorporate Brent crude as an explanatory
variable for PPI; it was found that deviations of Dated Brent Crude from the
long-term average of $18.80 was the best form of the variable to use (for
predictions the Brent forward curve produced by the Global Products Group is
used). The three new equations developed were:-

PLLU(t) = a.RPI(t) + b.RPI(t+N) + c.(DatedBrentCrude - 18.8) + constant,
where N is 14,15 or 16
[REDDISH CURVES]
r-squared approx 0.49
F-stat approx 32

The chart below shows what our projected PLLU curve would be given this
equation, and also the three best relations from before which were based upon
current and future RPI:

PLLU(t) = a.RPI(t) + b.RPI(t+N) + constant, where N is 14,15 or 16
[GREENISH CURVES]
r-squared approx 0.47
F-stat approx 45

COMPARISON OF MODELS
As you can see, the two equations differ in the very short-term and very
long-term; the inclusion of deviations of Brent Crude leads to short-term
predictions of 3.0% to 3.2% over the next six months. The greenish curves
predict PLLU in the range of 2.5% to 2.8% over the next six months.

The curves are then very similar until 2009, when the models including crude
break-away to the upside, relative to the falling RPI curve. The model based
purely on RPI hugs the RPI curve much more closely in the longer term. This
is only important to the extent that we have large positions beyond 2009
(which we don't).

SUGGESTION
What could be useful now is a differently-specified model designed to
forecast only the next 3 months, using auto-regressive or auto-regressive
error terms. This model would be far more accurate in the near-term, and we
could include this information onto the front of this long-term model. This
may be useful, despite the fact that most of our exposure is in future time
buckets.

BACK-TESTING

All the models give similar visual and statistical performance over the data
sample used (based mainly on 1990s "new paradigm" economy).

Hopefully we can discuss these and other points later in the tele-conference;
your ideas on this would be appreciated.

Regards,

Anjam
x35383