Deflation Risk

63 Pages Posted: 19 Jul 2013 Last revised: 25 Jan 2023

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 de- flation very similarly to other types of tail risks such as catastrophic insurance losses. In contrast, inflation tail risk has only a relatively small premium. De- flation 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.

Suggested Citation

Fleckenstein, Matthias and Longstaff, Francis A. and Lustig, Hanno N., Deflation Risk (July 2013). NBER Working Paper No. w19238, Available at SSRN: https://ssrn.com/abstract=2295853

Matthias Fleckenstein (Contact Author)

University of Delaware ( email )

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

Francis A. Longstaff

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

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

Hanno N. Lustig

Stanford Graduate School of Business ( email )

Stanford GSB
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United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

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United States

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