The Missing Piece of the Puzzle: Liquidity Premiums in Inflation-Indexed Markets
52 Pages Posted: 26 Sep 2017
Date Written: September 25, 2017
Fleckenstein et al. (2014) document that nominal Treasuries trade at higher prices than inflation-swapped indexed bonds, which exactly replicate the nominal cash flows. We study whether this mispricing arises from liquidity premiums in inflation-indexed bonds (TIPS) and inflation swaps. Using US data, we show that the level of liquidity affects TIPS, whereas swap yields include a liquidity risk premium. We also allow for liquidity effects in nominal bonds. These results are based on a model with a systematic liquidity risk factor and asset-specific liquidity characteristics. We show that these liquidity (risk) premiums explain a substantial part of the TIPS underpricing.
Keywords: Liquidity premium, liquidity risk, TIPS, inflation swaps, TIPS–Treasury puzzle
JEL Classification: C51, G12, G01, H63
Suggested Citation: Suggested Citation