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

Author

Listed:
  • Daniel L. Tortorice

    (Department of Economics, College of the Holy Cross)

  • Arben Kita

    (Highfield Campus, University of Southampton)

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.

Suggested Citation

  • Daniel L. Tortorice & Arben Kita, 2018. "Can Risk Models Extract Inflation Expectations from Financial Market Data? Evidence from the Inflation Protected Securities of Six Countries," Working Papers 1801, College of the Holy Cross, Department of Economics.
    • Handle: RePEc:hcx:wpaper:1801
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    References listed on IDEAS

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    Cited by:

    1. Olesya V. Grishchenko & Laura Wilcox, 2024. "Tale About Inflation Tails," Finance and Economics Discussion Series 2024-028, Board of Governors of the Federal Reserve System (U.S.).
    2. Olesya V. Grishchenko & Franck Moraux & Olga Pakulyak, 2025. "How Stable are Inflation Expectations in the Euro Area? Evidence from the Euro-Area Financial Markets," Finance and Economics Discussion Series 2025-041, Board of Governors of the Federal Reserve System (U.S.).

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    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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