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Can Risk Models Extract Inflation Expectations from Financial Market Data? Evidence from the Inflation Protected Securities of Six Countries

Daniel Tortorice () and Arben Kita ()
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Arben Kita: Highfield Campus, University of Southampton

No 1801, Working Papers from College of the Holy Cross, Department of Economics

Abstract: We consider an arbitrage strategy which exactly replicates the cash of of a sovereign inflation-indexed bond using infation swaps and nominal sovereign bonds. The strategy reveals a violation of the law of one price in the G7 countries which is largest for the eurozone. Testing the strategy's exposure to deflation, volatility, liquidity, economic and policy risks suggests that the observed pricing differential is an economic tail risk premium which is more pronounced in the eurozone. We conclude that ination expec- tations implied by models that view this pricing differential as compensation for risk are likely to be accurate and useful for policy-making.

Keywords: Inflation-Indexed Bonds; Nominal Bonds; Law of One Price; Mispricing; Limits to Arbitrage (search for similar items in EconPapers)
JEL-codes: G12 G15 G18 H63 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2018-04
New Economics Papers: this item is included in nep-eec
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