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Why Does the Treasury Issue Tips? The Tips–Treasury Bond Puzzle

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  • Matthias Fleckenstein
  • Francis A. Longstaff
  • Hanno Lustig

Abstract

We show that the price of a Treasury bond and an inflation-swapped TIPS issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS–Treasury mispricing has exceeded $56 billion, representing nearly eight percent of the total amount of TIPS outstanding. TIPS–Treasury mispricing is strongly related to supply factors such as Treasury debt issuance and the availability of collateral in the financial markets, and is correlated with other types of fixed-income arbitrages, These results pose a major puzzle to classical asset pricing theory. In addition, they raise the issue of why the Treasury issues TIPS, since in so doing it both gives up a valuable fiscal hedging option and leaves large amounts of money on the table.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16358.

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Date of creation: Sep 2010
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Publication status: published as The TIPS—Treasury Bond Puzzle* The Journal of Finance Accepted manuscript online: 30 JAN 2013, Matthias Fleckenstein, Francis A. Longstaff and Hanno Lustig DOI: 10.1111/jofi.12032
Handle: RePEc:nbr:nberwo:16358

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Cited by:
  1. Yuriy Kitsul & Jonathan H. Wright, 2012. "The Economics of Options-Implied Inflation Probability Density Functions," Economics Working Paper Archive 600, The Johns Hopkins University,Department of Economics.
  2. Yuriy Kitsul & Jonathan H. Wright, 2012. "The Economics of Options-Implied Inflation Probability Density Functions," NBER Working Papers 18195, National Bureau of Economic Research, Inc.
  3. Jens H.E. Christensen & James M. Gillan, 2011. "A model-independent maximum range for the liquidity correction of TIPS yields," Working Paper Series 2011-16, Federal Reserve Bank of San Francisco.
  4. Dong Lou & Hongjun Yan & Jinfan Zhang, 2013. "Anticipated and Repeated Shocks in Liquid Markets," Review of Financial Studies, Society for Financial Studies, vol. 26(8), pages 1891-1912.
  5. Robert Engle & Michael Fleming & Eric Ghysels & Giang Nguyen, 2012. "Liquidity, volatility, and flights to safety in the U.S. treasury market: evidence from a new class of dynamic order book models," Staff Reports 590, Federal Reserve Bank of New York.
  6. Iryna Kaminska & Dimitri Vayanos & Gabriele Zinna, 2011. "Preferred-Habitat Investors and the US Term Structure of Real Rates," FMG Discussion Papers dp674, Financial Markets Group.
  7. Bauer, Michael D., 2014. "Inflation expectations and the news," Working Paper Series 2014-9, Federal Reserve Bank of San Francisco.
  8. Stijn Van Nieuwerburgh & Hanno Lustig & Bryan Kelly, 2011. "Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees," 2011 Meeting Papers 1285, Society for Economic Dynamics.
  9. Michael J. Fleming & Neel Krishnan, 2009. "The microstructure of the TIPS market," Staff Reports 414, Federal Reserve Bank of New York.
  10. John H. Cochrane, 2011. "Discount Rates," NBER Working Papers 16972, National Bureau of Economic Research, Inc.
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  12. Jonathan Wright & Yuriy Kitsul, 2012. "The Economics of Options-Implied Inflation Probability Density Functions," 2012 Meeting Papers 174, Society for Economic Dynamics.
  13. Cartea, Álvaro & Saúl, Jonatan & Toro, Juan, 2012. "Optimal portfolio choice in real terms: Measuring the benefits of TIPS," Journal of Empirical Finance, Elsevier, vol. 19(5), pages 721-740.
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