IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/3009.html
   My bibliography  Save this paper

Inflation Insurance

Author

Listed:
  • Zvi Bodie

Abstract

A contract to insure $1 against inflation is equivalent to a European call option on the consumer price index. When there is no deductible this call option is equivalent to a forward contract on the CPI. Its price is the difference between the prices of a zero coupon real bond and a zero coupon nominal bond, both free of default risk. Provided that the risk-free real rate of interest is positive, the price of such an inflation insurance policy first rises and then falls with time to maturity. It is a decreasing function of the real interest rate and an increasing function of both the expected rate of inflation and the real risk premium on nominal bonds. When a deductible is introduced, the insurance policy can no longer be priced like a CPI forward contract. The option feature has its greatest value when the deductible is close to the forward rate of inflation, defined as the difference between the risk-free nominal and real interest rates. Such inflation insurance contracts are priced using the model developed by Black-Merton-Scholes. Pricing an inflation insurance policy with a cap requires only a minor modification of the model. The approach presented in this paper permits fairly precise quantification of the cost of implementing proposals to index pension benefits for inflation. It also gives us a way of estimating the savings to the Social Security system that would result from introducing a deductible.

Suggested Citation

  • Zvi Bodie, 1989. "Inflation Insurance," NBER Working Papers 3009, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:3009
    Note: ME
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w3009.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Zvi Bodie, 1982. "Investment Strategy in an Inflationary Environment," NBER Chapters, in: The Changing Roles of Debt and Equity in Financing U.S. Capital Formation, pages 47-64, National Bureau of Economic Research, Inc.
    2. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    3. Martin Feldstein, 1983. "Should Private Pensions Be Indexed?," NBER Chapters, in: Financial Aspects of the United States Pension System, pages 211-230, National Bureau of Economic Research, Inc.
    4. Hemming, Richard & Kay, John A, 1982. "The Costs of the State Earnings Related Pension Scheme," Economic Journal, Royal Economic Society, vol. 92(366), pages 300-319, June.
    5. Feldstein, Martin & Liebman, Jeffrey B., 2002. "Social security," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 4, chapter 32, pages 2245-2324, Elsevier.
    6. Martin Feldstein, 1980. "Social Security, Induced Retirement, and Aggregate Capital Accumulation:A Correction and Updating," NBER Working Papers 0579, National Bureau of Economic Research, Inc.
    7. Zvi Bodie, 1988. "Inflation, Index-Linked Bonds, and Asset Allocation," NBER Working Papers 2793, National Bureau of Economic Research, Inc.
    8. Joseph B. Grolnic & Alicia H. Munnell, 1986. "Should the U.S. government issue index bonds?," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 3-21.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Jeffrey R. Brown & Olivia S. Mitchell & James M. Poterba, 2001. "The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program," NBER Chapters, in: Risk Aspects of Investment-Based Social Security Reform, pages 321-370, National Bureau of Economic Research, Inc.
    2. Barr, Nicholas, 1992. "Economic theory and the welfare state : a survey and interpretation," LSE Research Online Documents on Economics 279, London School of Economics and Political Science, LSE Library.
    3. Jeffrey R. Brown & Olivia S. Mitchell & James M. Poterba, 2000. "Mortality Risk, Inflation Risk, and Annuity Products," NBER Working Papers 7812, National Bureau of Economic Research, Inc.
    4. Robert J. Shiller, 1997. "Public Resistance to Indexation: A Puzzle," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(1), pages 159-228.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Simon Gilchrist & Fabio M. Natalucci & Egon Zakrajsek, 2007. "Investment and the Cost of Capital: New Evidence from the Corporate Bond Market," Boston University - Department of Economics - Working Papers Series WP2007-027, Boston University - Department of Economics.
    2. Coleman Bazelon & Kent Smetters, 1999. "Discounting Inside the Washington D.C. Beltway," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 213-228, Fall.
    3. Martin Feldstein, 1991. "Domestic Saving and International Capital Movements in the Long Run and the Short Run," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 331-353, National Bureau of Economic Research, Inc.
    4. John Geanakoplos & Olivia S. Mitchell & Stephen P. Zeldes, "undated". "Social Security Money's Worth," Pension Research Council Working Papers 97-20, Wharton School Pension Research Council, University of Pennsylvania.
    5. C. Lee, 1998. "Life Cycle Savings in the United States, 1900-1990," CPE working papers 0014, University of Chicago - Centre for Population Economics.
    6. Martin Feldstein & Elena Ranguelova & Andrew Samwick, 2001. "The Transition to Investment-Based Social Security When Portfolio Returns and Capital Profitability Are Uncertain," NBER Chapters, in: Risk Aspects of Investment-Based Social Security Reform, pages 41-90, National Bureau of Economic Research, Inc.
    7. Kotlikoff, Laurence J, 1988. "Intergenerational Transfers and Savings," Journal of Economic Perspectives, American Economic Association, vol. 2(2), pages 41-58, Spring.
    8. Gustman, Alan L. & Steinmeier, Thomas L., 2001. "How effective is redistribution under the social security benefit formula?," Journal of Public Economics, Elsevier, vol. 82(1), pages 1-28, October.
    9. Shinichi Nishiyama & Kent Smetters, 2008. "The Optimal Design of Social Security Benefits," Working Papers wp197, University of Michigan, Michigan Retirement Research Center.
    10. Martin Feldstein, 1997. "Transition to a Fully Funded Pension System: Five Economic Issues," NBER Working Papers 6149, National Bureau of Economic Research, Inc.
    11. Ann McDermed & Robert L. Clark & Steven G. Allen, 1989. "Pension Wealth, Age-Wealth Profiles, and the Distribution of Net Worth," NBER Chapters, in: The Measurement of Saving, Investment, and Wealth, pages 689-736, National Bureau of Economic Research, Inc.
    12. Laurent E. Calvet & John Y. Campbell & Paolo Sodini, 2007. "Down or Out: Assessing the Welfare Costs of Household Investment Mistakes," Journal of Political Economy, University of Chicago Press, vol. 115(5), pages 707-747, October.
    13. Shiller, Robert J., 1999. "Social security and institutions for intergenerational, intragenerational, and international risk-sharing," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 50(1), pages 165-204, June.
    14. Martin Feldstein & Anthony J. Pellechio, 1977. "Social Security Wealth: The Impact of Alternative Inflation Adjustments," NBER Working Papers 0212, National Bureau of Economic Research, Inc.
    15. Ashraf, Nava & Karlan, Dean & Yin, Wesley, 2010. "Female Empowerment: Impact of a Commitment Savings Product in the Philippines," World Development, Elsevier, vol. 38(3), pages 333-344, March.
    16. MOUNA BEN OTHMAN & Mohamed Ali MAROUANI, 2016. "Labor Market Effects of Pension Reform :an overlapping genenrations general equilibrium model applied to Tunisia," EcoMod2016 9294, EcoMod.
    17. Valdes-Prieto, Salvador, 1994. "Distributive concerns when replacing a pay-as-you-go system with a fully funded system," Policy Research Working Paper Series 1366, The World Bank.
    18. Gottardi, Piero & Kubler, Felix, 2011. "Social security and risk sharing," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1078-1106, May.
    19. Borgmann, Christoph, 2002. "Labor income risk, demographic risk, and the design of (wage-indexed) social security," Discussion Papers 100, Albert-Ludwigs-Universität Freiburg, Institut für Finanzwissenschaft.
    20. Alvaro Forteza, 1998. "Los efectos de la Reforma uruguaya de la Seguridad Social en el ahorro," Documentos de Trabajo (working papers) 1098, Department of Economics - dECON.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:3009. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: the person in charge (email available below). General contact details of provider: https://edirc.repec.org/data/nberrus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.