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The Journal of Derivatives

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Pricing the Deflation Protection Option in TIPS Using an HJM Model with Inflation- and Interest-Rate Jumps

Ming-Che Chuang, Shih-Kuei Lin and Mi-Hsiu Chiang
The Journal of Derivatives Winter 2018, 26 (2) 50-69; DOI: https://doi.org/10.3905/jod.2018.1.069
Ming-Che Chuang
is an assistant professor in the Department of Finance at Feng Chia University in Taiwan
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Shih-Kuei Lin
is a professor in the Department of Money and Banking at National Chengchi University in Taiwan
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Mi-Hsiu Chiang
is an associate professor in the Department of Money and Banking at National Chengchi University in Taiwan
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Abstract

Much known about Treasury inflation-protected securities (TIPS) is related to the hedge they offer against inflation, but little is known about their protection against deflation—in the form of a deflation protection option (DPO). In this article, a pricing framework that builds on a Heath–Jarrow–Morton forward-rate economy with codependent inflation- and interest-rate jumps is derived to value this embedded DPO. The model prices for TIPS resulting from this pricing framework are found to most closely fit the 10-year notes issued following the 2008 crisis. Considering these notes accounted for over 70% of the total TIPS-market trading activity, this result underscores the importance of properly assessing DPO value in times of deflationary fears compounded by rising real yields, negligence of which may well be liable for the post-crisis mispricing in TIPS.

TOPICS: Fixed income and structured finance, quantitative methods, financial crises and financial market history

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The Journal of Derivatives: 26 (2)
The Journal of Derivatives
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Winter 2018
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Pricing the Deflation Protection Option in TIPS Using an HJM Model with Inflation- and Interest-Rate Jumps
Ming-Che Chuang, Shih-Kuei Lin, Mi-Hsiu Chiang
The Journal of Derivatives Nov 2018, 26 (2) 50-69; DOI: 10.3905/jod.2018.1.069

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Pricing the Deflation Protection Option in TIPS Using an HJM Model with Inflation- and Interest-Rate Jumps
Ming-Che Chuang, Shih-Kuei Lin, Mi-Hsiu Chiang
The Journal of Derivatives Nov 2018, 26 (2) 50-69; DOI: 10.3905/jod.2018.1.069
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