Inflation Risk Premium: Evidence from the TIPS Market

Abstract

This paper estimates inflation risk premia using data on prices of Treasury Inflation Protected Securities (TIPS) over the period 2000-2008. The estimation approach used is arbitrage free, largely model free, and easy to implement. It also distinguishes between TIPS yields and real yields by taking into account explicitly the three-month indexation lag of TIPS in the analysis. In addition, we consider three measures of the TIPS liquidity including one new measure based on TIPS prices only. We estimate the liquidity premium to be around 13 basis points over the full sample, but substantially higher in the first subperiod. We find that the inflation risk premium is time-varying and, on average, is considerably lower than suggested by various structural models. Specifically, depending on the proxy used for expected inflation, the average 10-year inflation risk premium ranges from -9 to 4 basis points over the full sample, and ranges between 1 and 6 basis points over the subperiod 2004-2008.

Keywords: TIPS market, inflation risk premium, TIPS liquidity, expected inflation, term structure of real rates, liquidity

JEL Classification: E31, E43, E44