Deflation Risk

62 Pages Posted: 13 Jul 2013

See all articles by Matthias Fleckenstein

Matthias Fleckenstein

University of Delaware

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

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Date Written: July 2013

Abstract

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5 percent over the next 30 years. Despite this, the market places substantial probability weight on deflation scenarios in which prices decline by more than 10 to 20 percent over extended horizons. We find that the market prices the economic tail risk of deflation very similarly to other types of tail risks such as catastrophic insurance losses. In contrast, inflation tail risk has only a relatively small premium. Deflation risk is also significantly linked to measures of financial tail risk such as swap spreads, corporate credit spreads, and the pricing of super senior tranches. These results indicate that systemic financial risk and deflation risk are closely related.

Keywords: deflation, tail risk

JEL Classification: G13

Suggested Citation

Fleckenstein, Matthias and Longstaff, Francis A. and Lustig, Hanno N., Deflation Risk (July 2013). Available at SSRN: https://ssrn.com/abstract=2293210 or http://dx.doi.org/10.2139/ssrn.2293210

Matthias Fleckenstein

University of Delaware ( email )

419 Purnell Hall
Newark, DE 19716
United States
3028314936 (Phone)

HOME PAGE: http://www.mfleckenstein.com

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

Hanno N. Lustig

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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