Relative pricing of French Treasury inflation-linked and nominal bonds: an empirical approach using arbitrage strategies
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Relative pricing of French Treasury inflation-linked and nominal bonds: an empirical approach using arbitrage strategies Béatrice de Séverac 1
& José
S. da Fonseca 2
Received: 11 January 2019 / Accepted: 21 September 2020/ # ISEG – Instituto Superior de Economia e Gestão 2020
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. Keywords Arbitrage . Duration . Inflation-linked bonds . Real interest rates . Inflation risk JEL classification E43 . G01 . G12
1 Introduction The relative pricing of inflation-linked (IL) bonds and nominal bonds has recently become a subject of interest. Understanding whether IL bonds are correctly priced
* Béatrice de Séverac [email protected] José S. da Fonseca [email protected]
1
Université Paris Nanterre, UFR SEGMI, Bâtiment Maurice Allais, 200 Avenue de la République, 92001 Nanterre Cedex, France
2
CeBER, Faculty of Economics, University of Coimbra, Portugal, Av. Dias da Silva 165, 3004-512 Coimbra, Portugal
B. de Séverac, J. S. da Fonseca
relative to their nominal counterparts is important. First, IL bonds are the only assets that offer a nearly perfect hedge against inflation. They are very useful for long-range planning investments for individuals and institutions alike. On the issuer’s side, treasuries need to know whether these assets are more costly to issue than nominal bonds. Second, IL bonds directly determine the breakeven inflation rate, which reflects inflation expectations and represents compensation to investors for bearing inflation risk. Mispricing between IL and nominal bonds can distort the estimation of the breakeven inflation rate and thus the estimation of inflation expectations. It can also lead to arbitrage opportunities between these two assets. Recent literature analyzes potential mispricing between IL and nominal bonds (Kupfer 2018). Christensen and Gillan (2012) were the first to compare nominal and IL bonds yields by focusing on the potential savings the US Treasury can gain by issuing IL bonds. Pflueger and Viceira (2011, 2013) adopt an empirical approach to estimate and explore the sources of the IL and nominal bond risk premiums in the United States and in the United Kingdom. They conclude that Treasury Inflation Protected Securities (TIPS) are not undervalued. Inst
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