The Informational Content of the Embedded Deflation Option in TIPS

71 Pages Posted: 22 Oct 2010 Last revised: 4 Oct 2011

See all articles by Olesya V. Grishchenko

Olesya V. Grishchenko

Board of Governors of the Federal Reserve System

Joel M. Vanden

Pennsylvania State University - Smeal College of Business

Jianing Zhang

Pennsylvania State University - Smeal College of Business

Date Written: October 4, 2011

Abstract

In this paper we estimate the value of the embedded option in U.S. Treasury Inflation Protected Securities (TIPS). The option value exhibits significant time variation that is correlated with periods of deflationary expectations. We use our estimated option values to construct an embedded option price index and an embedded option return index. We then use our embedded option indices as independent variables and examine their statistical and economic significance for explaining the future inflation rate. In ost of our regressions, our embedded option return index is significant even in the presence of traditional inflation variables, such as the yield spread between nominal Treasuries and TIPS, the return on gold bullion, the VIX index return, and the lagged inflation rate. We conduct several robustness tests, including alternative weighting schemes, alternative variable specifications, and alternative data samples. We conclude that the embedded option in TIPS contains useful information for future inflation, both in-sample and out-of-sample. Our results should be valuable to practitioners, monetary authorities, and policymakers alike.

Keywords: TIPS, embedded option, inflation, deflation, term structure

JEL Classification: E31, E43, E44, G12

Suggested Citation

Grishchenko, Olesya V. and Vanden, Joel M. and Zhang, Jianing, The Informational Content of the Embedded Deflation Option in TIPS (October 4, 2011). Paris December 2010 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=1695511

Olesya V. Grishchenko (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2981 (Phone)

Joel M. Vanden

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States

Jianing Zhang

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States

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