The TIPS Liquidity Premium

Keywords: term structure modelling, liquidity risk, financial market frictions.
  • 28 Julio 2017

Por Martin M. Andreasen, Jens H. E. Christensen y Simon Riddell

Federal Reserve Bank of San Francisco Working Paper 2017-11.

Abstract:

We introduce a new arbitrage-free term structure model of nominal and real yields that accounts for liquidity risk in Treasury inflation-protected securities (TIPS). The novel feature of our model is to identify liquidity risk directly from individual TIPS prices by accounting for the tendency that TIPS, like most fixed-income securities, go into buyand-hold investors’ portfolios as time passes. We find a sizable and countercyclical TIPS liquidity premium, which greatly helps our model in matching TIPS prices. Accounting for liquidity risk also improves the model’s ability to forecast inflation and match inflation surveys, although none of these series are included in the estimation.