TREASURY INFLATION PROTECTED SECURITIES AND NOMINAL BONDS - THE DEVELOPMENT OF SOME EMPIRICAL FEATURES

Abstract

This study focuses to examine nominal and inflation-linked bond behavior in the time period of February 2004 – August 2011 – giving some special attention to the year of crisis, 2008. The qualities being examined are return, risk and correlation between a nominal and an inflation protected bond.

Efficient market hypothesis is used to explain why the best guess of tomorrow´s asset price is today´s price. The difference between real and nominal rates and inflation´s role in bond pricing is explained with the help of the Fisher equation. Pricing formulas and pricing fundamentals are explained carefully. The research was conducted by examining one 10-year nominal US Treasury bond and one 10-year Treasury inflation protected security. Daily returns were computed from daily prices. Also correlation and standard deviation were computed from daily returns. Two multivariate regressions were used for further analysis.

The results show that the impact of the crisis can clearly be seen in the development of the empirical features. In 2008, the correlation dropped from the upper 80 percent range to be near 0.5. With the help of the multivariate regression analysis´ results it can be stated that rising inflation expectations are behind increasing correlation and bond demand is a reason why the correlation decreases. Inflation expectations cause the index-linked bond price to increase more in relation to the nominal bond price. Rising demand causes the price of the nominal bond to increase more than the price of the index-linked bond. The returns of the bonds deviated strongly in 2008. Nominal bond returns were more volatile than index-linked bond returns most of the time.