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The deflation protection option embedded in Treasury inflation-protected securities (TIPS) has received limited attention in the literature. However, since the financial crisis of 2008-2009, elevated spreads of seemingly identical TIPS bonds distinguished only by their issuance date suggest that the value of this deflation protection has been sizable. We use an arbitrage-free, Nelson-Siegel term structure model with spanned stochastic volatility to determine the value of this deflation option. The model accurately prices the deflation protection option prior to the financial crisis when its value was near zero and during the peak of the crisis in late 2008 when deflationary concerns spiked sharply. During 2009, the average value of this option was 41 basis points. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. This draft was prepared for presentation at the FDIC’s 21st Annual Derivative Securities and Risk Management Conference. This version: June 1, 2011.

Pricing Deflation Risk with U.S. Treasury Yields