Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 40. A Framework for Valuing Treasury Inflation-Protected Securities

PRIYA MISRA

Senior Vice President, Lehman Brothers Inc.

KODJO APEDJINOU

Vice President, Lehman Brothers Inc.

ANSHUL PRADHAN

Associate, Lehman Brothers Inc.

Abstract: Treasury inflation-protected securities (TIPS) offer investors near-complete protection against inflation risk because both their coupon and principal payments are adjusted for realized inflation. Investors in nominal Treasury bonds demand compensation not only for expected inflation but also for the uncertainty surrounding inflation expectations, referred to as the inflation risk premium. Inflation expectations implied by the market can be deduced by comparing the yields of nominal Treasury bonds with the yields of similar-maturity TIPS. However, the difference in yields between nominal bonds and TIPS, known as the breakeven spread, needs to be adjusted for: the inflation risk premium; the difference in convexity value between nominal and TIPS; and the liquidity premium of nominal Treasuries.

Keywords: Treasury bonds, Treasury inflation-protected securities (TIPS), convexity, risk premium, inflation expectations

The U.S. Treasury started issuing inflation indexed securities in January 1997. Unlike regular nominal Treasury bonds, these Treasury inflation-protected securities (TIPS) offer investors near-complete protection against inflation risk. Indeed, both the semiannual coupons and the principal payments of TIPS are adjusted for changes in the non-seasonally-adjusted ...