TIPS AND THE EMBEDDED DEFLATION PUT OPTION

Abstract

Previous studies in US Treasury Inflation-Protected Securities (TIPS) tend to ignore the embedded deflation put option which guaranties that bondholders are not adversely affected by deflation. In essence, most researchers implicitly or explicitly assume that the option values are trivial and treat the principal payments of TIPS as fully adjusted for inflation. However, recent economic turmoil and uncertainty about future market conditions make this assumption questionable. Our estimation from empirical data suggests that the option values can be non-trivial and exhibit substantial time variation which closely matches market incidents such as Lehman‘s bankruptcy and the onset of European sovereign debt crisis. We also find the theoretical option values obtained by substituting historical volatility into the Jacoby and Shiller (2007) model are mostly smaller than the empirical option values.