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

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.