Document Type

Working Paper

Date of This Version

4-1-2018

Keywords

Inflation-Indexed Bonds, Nominal Bonds, Law of One Price, Mispricing, Limits to Arbitrage

JEL Classification

G12, G15, G18, H63

Abstract

We consider an arbitrage strategy which exactly replicates the cash of a sovereign inflation-indexed bond using inflation 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 inflation expectations implied by models that view this pricing differential as compensation for risk are likely to be accurate and useful for policy-making.

Working Paper Number

1801

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