The information content of the deflation put options in TIPs

Abstract

Most prior literature in the research of US Treasury Inflation-Protected Securities (TIPS) often ignores the embedded deflation put option which guarantees that bondholders are not adversely affected by deflation. In this paper, I argue that the deflation put option is non-trivial and there is rich information content that can be exploited. My estimation shows that the at-the-money 5-year maturity deflation put option has a positive and significant value throughout the sample period over the last 10 years, covering both pre-crisis economy expansion period and post-crisis recession period. Regressions analyses reveal the rich information content of the deflation put option. The option values and returns are significantly correlated with contemporaneous and future realized inflation up to 4 months ahead, even when other common inflation expectation measures are included in the regressions. Furthermore, the option returns are also highly correlated with commodity market returns and global equity market returns.