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Deflation Risk

Author

Listed:
  • Matthias Fleckenstein
  • Francis A. Longstaff
  • Hanno Lustig

Abstract

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5% over the next 30 years. Despite this, the market places substantial weight on deflation scenarios in which prices significantly decline over extended horizons. The market prices the economic tail risk of deflation similarly to other types of tail risks, such as corporate default or catastrophic insurance losses. We find that deflation risk is strongly negatively correlated with outcomes in the financial markets and with consumer confidence.Received January 26, 2015; editorial decision November 14, 2016 by Editor Leonid Kogan.

Suggested Citation

  • Matthias Fleckenstein & Francis A. Longstaff & Hanno Lustig, 2017. "Deflation Risk," The Review of Financial Studies, Society for Financial Studies, vol. 30(8), pages 2719-2760.
    • Handle: RePEc:oup:rfinst:v:30:y:2017:i:8:p:2719-2760.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhx021
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    More about this item

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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