Date of This Version
Inflation-Indexed Bonds, Nominal Bonds, Law of One Price, Mispricing, Limits to Arbitrage
G12, G15, G18, H63
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
Kita, Arben and Tortorice, Daniel L., "Can Risk Models Extract Inflation Expectations from Financial Market Data? Evidence from the Inflation Protected Securities of Six Countries" (2018). Economics Department Working Papers. Paper 184.