Relative pricing of French Treasury inflation-linked and nominal bonds: an empirical approach using arbitrage strategies

Abstract

This paper investigates whether arbitrage opportunities exist between inflation-linked bonds and nominal bonds on the French Treasury market. Following arbitrage theory, we apply the risk hedging concept: we set up self-financing portfolios hedged against risks through durations of different orders. Perfectly hedged portfolios are those with a zero initial and a zero final value. The results show arbitrage gains when the first three duration orders are implemented, but they are not significantly different from zero when a fourth-order duration is added. Furthermore, a regression of arbitrage gains on the illiquidity measure of nominal and index Treasury bonds provides evidence that the illiquidity of inflation-linked bonds significantly explains arbitrage gains, whereas the illiquidity measure of nominal bonds does not.