Inflation-Linked and Nominal Government Bonds Puzzle - New Evidence from the Israeli Market

Abstract

Flekenstein, Longstaff and Lustig (2014) find mispricing between Treasury bonds and Treasury Inflation-Protected Securities (TIPS) in the United States, suggesting that Treasury bonds are expensive relative to TIPS. I examine the existence of a mispricing in the Israeli government bond market, a market with different characteristics. I find that in Israel the mispricing is in the opposite direction and it is positively affected by the last inflation surprise known at the time the arbitrage strategy is executed. Given these results, it appears that the mispricing opportunity documented by Flekenstein, Longstaff and Lustig (2014) does not work in a single direction.

Keywords: Government Bonds; Inflation; International Financial Markets; Market efficiency

JEL Classification: E3, G12, G14, G15, G18, H63