Pricing Deflation Risk with U.S. Treasury Yields

Authors

Jose A. Lopez

Glenn D. Rudebusch

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2012-07 | July 1, 2014

We use an arbitrage-free term structure model with spanned stochastic volatility to determine the value of the deflation protection option embedded in Treasury inflation protected securities (TIPS). The model accurately prices the deflation protection option prior to the financial crisis when its value was near zero; at the peak of the crisis in late 2008 when deflationary concerns spiked sharply; and in the post-crisis period. During 2009, the average value of this option at the five-year maturity was 41 basis points on a par-yield basis. The option value is shown to be closely linked to overall market uncertainty as measured by the VIX, especially during and after the 2008 financial crisis.

Article Citation

Rudebusch, Glenn D., Jens H. E. Christensen, and Jose A. Lopez. 2012. “Pricing Deflation Risk with U.S. Treasury Yields,” Federal Reserve Bank of San Francisco Working Paper 2012-07. Available at https://doi.org/10.24148/wp2012-07

About the Author
Jens Christensen
Jens Christensen is a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Jens Christensen