Abstract
AbstractWe consider an arbitrage strategy that exactly replicates the cash flow of a sovereign nominal bond using inflation swaps and inflation‐linked bonds. The strategy reveals a violation of the law of one price in the G7 countries, which is largest for the eurozone. Testing the strategy's exposure to deflation, volatility, liquidity, and macro‐economic risks shows the observed mispricing is a risk premium, which is more pronounced in the eurozone. We find less support that financial limits to arbitrage explain the mispricing. We conclude that pure long‐run arbitrage opportunities persist when these strategies are exposed to intermediate financial risks.
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