Cheap TIPS or Expensive Inflation Swaps? Mispricing in Real Asset Markets

66 Pages Posted: 9 Feb 2019 Last revised: 10 Apr 2019

See all articles by Thuy Duong To

Thuy Duong To

University of New South Wales, Sydney; Financial Research Network (FIRN)

Ngoc-Khanh Tran

Pamplin College of Business - Virginia Tech

Date Written: January 28, 2019

Abstract

Inflation risks are explicit in either (i) the nominal pricing of real payoffs in which prices are denominated in dollars, or (ii) the real pricing of nominal payoffs in which prices are denominated in consumption baskets. While the former involves over-the-counter inflation-indexed contracts of real asset market, the latter involves exchange-traded and highly liquid contracts of nominal asset market. We employ a parametric pricing model to investigate the asymmetry between these two markets. The model obtains a liquidity-free distribution of future inflation using new price data of T-note futures in nominal asset market, and implies liquidity risk premia separately for any traded contract in real asset market. These premia indicate both an underpricing for TIPS and an overpricing for inflation swaps, whose significances increase with the tenor of these assets. Such a mispricing in inflation swaps help temper a severe implied mispricing of TIPS needed to match the puzzling trade profit on the nominal-TIPS yield spread. While yields on TIPS still command a liquidity component, this finding implicates less pronounced borrowing costs to the U.S. government in issuing TIPS.

Keywords: Inflation, TIPS, Swap, Liquidity, Mispricing

JEL Classification: E31, G12, G13

Suggested Citation

To, Thuy Duong and Tran, Ngoc-Khanh, Cheap TIPS or Expensive Inflation Swaps? Mispricing in Real Asset Markets (January 28, 2019). Available at SSRN: https://ssrn.com/abstract=3324915 or http://dx.doi.org/10.2139/ssrn.3324915

Thuy Duong To

University of New South Wales, Sydney ( email )

School of Banking and Finance,
University of New South Wales
Sydney, 2052
Australia
61295855865 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Ngoc-Khanh Tran (Contact Author)

Pamplin College of Business - Virginia Tech ( email )

Pamplin 2126
880 West Campus Drive
Blacksburg, VA 24061
United States

HOME PAGE: http://https://www.nktran.com/

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