Pricing Inflation Linked Bonds

Abstract

This paper advances a pricing model for inflation linked bonds. Our proposal is developed starting from a Vasicek model of the instantaneous inflation rate process (Vasicek, 1977) and the Cox, Ingersoll, and Ross (CIR) model for the nominal instantaneous risk-free interest rate process (Cox, Ingersoll, Ross, 1985). Instead of adopting the standard approach of a cross-section estimation of the term structure of real interest rates, this work proposes a pricing model based on the estimation of inflation risk premium. The model is applied to Treasury Inflation Protected Securities (TIPS's), which are inflation linked bonds issued by the U. S. Department of the Treasury. Empirical validation is carried out on data in the period 1999-2005.