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Pricing deflation risk with U.S. Treasury yields

  • Jens H.E. Christensen
  • Jose A. Lopez
  • Glenn D. Rudebusch

We use an arbitrage-free term structure model with spanned stochastic volatility to determine the value of the deflation protection option embedded in Treasury inflation-protected securities (TIPS). The model accurately prices the deflation protection option prior to the financial crisis when its value was near zero; at the peak of the crisis in late 2008 when deflationary concerns spiked sharply; and in the post-crisis period. During 2009, the average value of this option at the five-year maturity was 41 basis points on a par-yield basis.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2012-07.

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Date of creation: 2012
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Handle: RePEc:fip:fedfwp:2012-07
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  1. Jens H. E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2010. "Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 143-178, 09.
  2. Jens H.E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2012. "Extracting Deflation Probability Forecasts from Treasury Yields," International Journal of Central Banking, International Journal of Central Banking, vol. 8(4), pages 21-60, December.
  3. Philippe Mueller & Mikhail Chernov, 2008. "The Term Structure of Inflation Expectations," 2008 Meeting Papers 346, Society for Economic Dynamics.
  4. 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.
  5. Christensen, Jens H.E. & Lopez, Jose A. & Rudebusch, Glenn D., 2014. "Can spanned term structure factors drive stochastic yield volatility?," Working Paper Series 2014-3, Federal Reserve Bank of San Francisco.
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