How would you suggest answering this question? In the U.S. these bonds are only 5 years old, but there are a flurry of suggestions that TIPS are cheap. Do I smell a rat? I would appreciate any opinions and/or suggestions on ways to investigate and answer this question.Thanks,Mc

The obvious pricing is that TIPS yield equals the fixed treasury of the same maturity minus the expected average inflation rate over the period. On this basis, TIPS look cheap. But there are some caveats.(1) Many (most?) people who buy short and medium term treasuries want the liquidity. They're not necessarily buying them because they like the yield over the entire period. TIPS are much less liquid. It makes more sense to compare TIPS yield to less liquid investments like commercial paper and municipal bonds, even though these have more credit risk.(2) TIPS are tax-disadvantaged since you pay taxes on the inflation over the life and only get the benefit over time. (3) TIPS suffer from a risk if the definition of CPI is changed (although this is partially offset by the terms of the securities). I think this is a significant risk over 5 and 10 year periods.

Yes, but given those and other caveats are TIPS really cheap as Bill Gross insists? What is the put option worth?Is it valued correctly?Also why did the maturing 5-yr TIPS behave so erratically near expiration- Negitive yields and high volatility in yields?The idea that the TIPS yield = Nominal - expected average inflation rate, seems inaccurate. Too many other factors aren't there?mc

I don't know how cheap Bill Gross says TIPS are. The analyses I've seen compare the yield spreads of TIPS over same-maturity treasuries with inflation forecasts. I agree that this is too simple.Basically, I think the market is saying that it expects real interest rates to go up. That makes TIPS relatively unattractive. They have to be cheap on a current yield/current inflation expectation basis for people to buy them. And they are penalized more than medium-term treasury securities because they are held more by retail investors and they are harder to trade when rates start to move.I don't know about the puts. Are you referring to a specific article?

QuoteOriginally posted by: mcYes, but given those and other caveats are TIPS really cheap as Bill Gross insists? What is the put option worth?Is it valued correctly? . . . . thereis am implicit put on [savings bond] series I-Bonds, but i was unaware of any put on TIPS

No, I am not refering to any particular article when I ask if TIPS are really "cheap". I have seen this repeatedly in the last 6 months from multiple sources. As I look into TIPS, I believe this is due to multiple factors. A few of which are????) 1)TIPS have been discovered by funds eager to sell to more risk averse than (historical) average investors due to, among other things, the equity bubble breaking. They are now pushing a product that appeals to those who have been burned. Investors have already run to Nominals. 2)TIPS are very illiquid, with a wide bid/ask spread is it possible to make that large spread when selling to less informed investors? 3)The question regarding the put option, was an attempt to see if this was where the value might be. What I am referring to, is the guarantee of full principal return in the event of Deflation - a deflation floor so to speak. I do see that since I asked that question Greenspan uttered the D word and not only did yields hit new lows but TIPS yields went even lower. Was this a repricing of the ignored deflation floor or put option? Before his words it seemed that no one was considering this side of TIPS. How would one value this option? Monte Carlo simulation?Maybe TIPS are overvalued....I think the liquidity of TIPS is a major problem. Yet how do you get data that actually shows actual prices, when traded, bid/ask spreads, etc that can be used in comparison to the benchmarks?Alot of words and questions, I would appreciate any thoughts on this subject.

QuoteOriginally posted by: mc. . . 3)The question regarding the put option, was an attempt to see if this was where the value might be. What I am referring to, is the guarantee of full principal return in the event of Deflation - a deflation floor so to speak. I do see that since I asked that question Greenspan uttered the D word and not only did yields hit new lows but TIPS yields went even lower. Was this a repricing of the ignored deflation floor or put option? . . . how is this a put? . . . a riskless government Treasury Bond repays 100% principal upon maturity, how is that different from any other Treasury Bond? . . .

From my limited understanding of the mechanics of TIPs, the put option refers to the fact that if there's deflation, there's a floor of 0% in the inflation indexation; you don't have to take a haircut. So at low levels of inflation, I guess this option could be pretty valuable.Not sure how to value this option; you obviously need a model of inflation dynamics, and everyone will have their own ideas on this. I'm sure there is lots of serious work being done on this, but I'm equally sure that it's still pretty speculative, especially now that there is a possibility of regime change compared to experience of past few decades.I also think that when most people express the opinion that TIPs are cheap, they are really approaching it from the point of view that nominal Treasuries are expensive, and casting around for a defensive alternative, rather than rigorously analysing the value of TIPs.

I'm not sure how to answer the question of whether TIPS are "cheap" or not, but some known facts are:1) TIPS seem to be uncorrelated with most other asset classes. This makes them attractive for portfolio diversification2) Returns on TIPS seem to have outperformed all other asset classes in both 2001 and 2002. This statement should of course be interpreted with care, since we all know that high returns come at a price (high risk) and vice versa.For a clarification of these claims, see McCulloch's homepage.TIPS as well as French real rate bonds (both on French inflation and on Eurozone inflation) has a deflation guarantee, i.e. a put option on the compounded inflation over the bond lifetime. Personally I'd suggest that this option is discarded in option pricing, but it is quite difficult to quantify it, as the bonds themselves are the only available real rate securities. Actually Sweden has issued real rate government bonds where some have a deflation guarantee and some have not, but they have different maturities so prices can not be compared directly.Option value will depend on the model chosen for inflation rate dynamics (or for compounded inflation). Straightforward modeling of the inflation rate e.g. by a geometric brownian motion is likely to lead to too large option values, and some notion of mean-reversion should probably be built in to the model. Volatility and mean reversion speed will have to be estimated from historical data (of forward inflation rates), but what is needed in pricing is actually these parameters under the risk neutral measure, so some "hand-tuning" will be required. On top of this some "predictability" should be built into the model, both in the form of seasonality, but also because long-term forward inflation levels seem to be trading close to current (realized) inflation rates.The possibility of a regime switch also makes inflation rate modeling pretty speculative. Looking at historical data, it has been extremely rare that deflation over a 10-year period has occured (or other periods similar to the bond maturities that real rate bonds typically have), and chances are pretty good that the have occured in connection with World War I or II.Moreover, countries that issue real rate bonds typically do so in order to give more credibility to their monetary policy. This means that it is likely that a regime switch has actually occurred upon deciding to issue real rate bonds, and hence available time series of inflation rates etc. must be truncated to the period in which real rate bonds have been traded. For the US case that would mean the period from 1997, considerably less than the 30-year horizon that must be considered for some TIPS bonds.

In returning to the deflation floor talk - The embedded Put option in TIPS.I see why the put option is so far worthless - CPI had increased and put is far out-of-the-money.But a new 10-yr (30-yr Better ex. but canceled) in the present environment that the Fed 'says' there is more danger of D than I, shouldn't this give some value to the put ?I guess that the penalty (if I have this correct and I believe I do) is that the principal still goes down wrt the coupon payments calculations (further back loading). Thus the penalty in an inflationary environment is severe. The inflation floor is of little value ten years- back loaded. The bond would not perform well in spite of the deflation floor at expiration. Thus, if there is expected deflation it is best to buy long-term nominals. I think this makes sense...any thoughtsWhat would be the best way to crudely view the put in excel.Could you use B-S to create possible prices?Could you use Monte Carlo Crystal Ball or @Risk?