We introduce an arbitrage-free term structure model of nominal and real yields that accounts for liquidity risk in Treasury inflation-protected securities (TIPS). The novel feature of our model is to identify liquidity risk from individual TIPS prices by accounting for the tendency that TIPS, like most fixed-income securities, go into buy-and-hold investors’ portfolios as time passes. We find a sizable and countercyclical TIPS liquidity premium, which helps our model to match TIPS prices. Accounting for liquidity risk also improves the model’s ability to forecast inflation and match surveys of inflation expectations, although these series are not included in the estimation.
Christensen, Jens H. E., Martin M. Andreasen, and Simon Riddell. 2017. “The TIPS Liquidity Premium,” Federal Reserve Bank of San Francisco Working Paper 2017-11. Available at https://doi.org/10.24148/wp2017-11