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

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.