Article | Annual Review of Financial Economics | December 2011

Inflation-Indexed Bonds and the Expectations Hypothesis

by Carolin E. Pflueger and Luis M. Viceira

Abstract

This paper empirically analyzes the Expectations Hypothesis (EH) in inflation-indexed (or real) bonds and in nominal bonds in the U.S. and in the U.K. We strongly reject the EH in inflation-indexed bonds and also confirm and update the existing evidence rejecting the EH in nominal bonds. This rejection implies that the risk premium on both real and nominal bonds varies predictably over time. We also find strong evidence that the spread between the nominal and the real bond risk premium, or the breakeven inflation risk premium, also varies over time. We argue that the time variation in real bond risk premia most likely reflects both a changing real interest rate risk premium and a changing liquidity risk premium, and that the variability in the nominal bond risk premia reflects a changing inflation risk premium. We estimate significant time series variability in the magnitude and sign of bond risk premia.

Keywords: Risk Management; Bonds; Financial Liquidity; Inflation and Deflation; United Kingdom; United States;

Citation:

Pflueger, Carolin E., and Luis M. Viceira. "Inflation-Indexed Bonds and the Expectations Hypothesis." Annual Review of Financial Economics 3 (December 2011): 139–158.