Pricing the term structure of inflation risk premia: Theory and evidence from TIPS

Chen, Ren‐Raw; Liu, Bo; Cheng, Xiaolin

doi:10.1016/j.jempfin.2010.01.002

Cited by 83 publications

(46 citation statements)

References 48 publications

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“…Recent studies include Wei (2008), D'Amico, Kim, and, Chen, Liu, and Cheng (2010), Christensen, Lopez, andRudebusch (2010), Haubrich, Pennacchi andRitchken (2012), and Campbell, Sunderam, and Viceira (2013). Our findings differ from these studies, which either do not study return-predictability or find inconclusive evidence (Haubrich, Pennacchi, and Ritchken, 2012).…”

contrasting

confidence: 91%

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Pflueger

Viceira²

2011

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Estimating the liquidity differential between inflation-indexed and nominal bond yields, we separately test for time-varying real rate risk premia, inflation risk premia, and liquidity premia in U.S. and U.K. bond markets. We find strong, model independent evidence that real rate risk premia and inflation risk premia contribute to nominal bond excess return predictability to quantitatively similar degrees. The estimated liquidity premium between U.S. inflation-indexed and nominal yields is systematic, ranges from 30 bps in 2005 to over 150 bps during [2008][2009], and contributes to return predictability in inflation-indexed bonds. We find no evidence that bond supply shocks generate return predictability. (Fama and Bliss, 1987), the slope of the yield curve (Campbell and Shiller, 1991), and a linear combination of forward rates (Cochrane and Piazzesi, 2005).There is however an ongoing discussion about what drives this predictability. We contribute to this discussion by conducting a joint empirical analysis of the sources of excess bond return predictability in nominal and inflation-indexed bonds in the U.S. and the U.K. Specifically, we provide evidence that both time-varying inflation risk premia and time-varying real interest rate risk premia are quantitatively important in explaining time variation in the expected excess return on nominal bonds.The question whether expected excess returns of inflation-indexed bonds are time-varying is important on its own. It remains relatively unexplored, partly due to the short history of U.S.inflation-indexed bonds (Campbell, Shiller, and Viceira, 2009). We contribute to the emerging research on inflation-indexed bonds by examining and distinguishing among three potential sources of excess return predictability in inflation-indexed bonds: time-varying real interest rate risk, timevarying liquidity risk, and market segmentation. Our work differs from recent work on inflationindexed bond return predictability by Campbell, Sunderam, and Viceira (2013) and Pflueger and Viceira (2011) in that it finds and corrects for an economically significant liquidity risk premium, which otherwise would likely distort estimates of real rate and inflation risk premia.Novel and unique to our work is the finding that a liquidity component in breakeven inflation, or the spread between nominal and inflation-indexed bond yields of similar maturity, predicts the return differential between nominal and inflation-indexed bonds due to liquidity. The estimated U.S. return differential due to liquidity exhibits a significantly positive stock market CAPM beta, suggesting that U.S. TIPS investors bear systematic liquidity risk and should be compensated in terms of a positive return premium. While the return differential due to liquidity is not directly 1 tradable, this result is relevant to investors who may differ in terms of their exposure to liquidity crises.Research in financial economics has proposed several theories to explain predictability in nominal excess bond returns. One hypothes...

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confidence: 91%

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Pflueger

Viceira²

2011

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“…7 As they are based on TIPS data, they are not net of inflation risk premium effects. However, as shown in the literature, the inflation rate risk premium effects are quite stable over our sample and they are fairly small (see, e.g., Chen et al (2010) and Christensen et al (2010)). In particular, Christensen et al find that inflation premia vary in a range around zero ± 50 basis points for the 5 and 10-years maturity horizons.…”

Section: Empirical Analysissupporting

confidence: 73%

Real term structure forecasts of consumption growth

Argyropoulos

Tzavalis

2015

Journal of Empirical Finance

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“…Recall that the yields on nominal and inflation-indexed bonds maturing in n periods are denoted as y (n) j,t , j = N, R, respectively, so let their zero-risk premium counterparts be y (n) j,t (φ = 0), j = N, R. Second, define the date t nominal and 32 Our approach is similar to Chen, Liu, and Cheng (2010) but differs from Christensen, Lopez, and Rudebusch (2010) who define an inflation risk premium as the residual from subtracting the rate of expected inflation from the breakeven inflation rate: y (27)- (29). Because the rate of expected inflation exceeds the expected rate of inflation due to Jensen's Inequality,…”

Section: Expected Inflation and Inflation Risk Premiamentioning

confidence: 99%

“…Note that identifying the parameters of a joint model of nominal and real term structures requires more than just information on nominal yields. Previous work using U.S. data typically employs nominal Treasury yields along with data on Treasury Inflation Protected Securities (TIPS) (D'Amico, Kim, and Wei (2008), Chen, Liu, and Cheng (2010), Christensen, Lopez, and Rudebusch (2010)) or data on survey forecasts of inflation (Pennacchi (1991), Chernov and Mueller (2008)). …”

Section: Introductionmentioning

confidence: 99%

Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps

Haubrich

Pennacchi²,

Ritchken³

2011

Working Paper (Federal Reserve Bank of Cleveland)

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This paper develops a model of the term structures of nominal and real interest rates driven by state variables representing the short-term real interest rate, expected infl ation, infl ation's central tendency, and four volatility factors that follow GARCH processes. We derive analytical solutions for nominal bond yields, yields on infl ation-indexed bonds that have an indexation lag, and the term structure of expected infl ation. Unlike prior studies, the model's parameters are estimated using data on infl ation swap rates, as well as nominal yields and survey forecasts of infl ation. The volatility state variables fully determine bonds' timevarying risk premia and allow for stochastic volatility and correlation between bond yields, yet they have small effects on the cross section of nominal yields. Allowing for time-varying volatility is particularly important for real interest rate and expected infl ation processes, but long-horizon real and infl ation risk premia are relatively stable. Comparing our model prices of infl ation-indexed bonds to those of Treasury Infl ation Protected Securities (TIPS) suggests that TIPS were signifi cantly underpriced prior to 2004 and again during the 2008-2009 fi nancial crisis.

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Pricing the term structure of inflation risk premia: Theory and evidence from TIPS

Cited by 83 publications

References 48 publications

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Real term structure forecasts of consumption growth

Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps

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