Pricing inflation indexed bonds and embedded deflation floor options: An analysis on Turkish bond market

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2020-9

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Bayram, Berat

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Fixed income securities are financial contracts that provide a stream of cash flows to the investors. Such cash flows are exposed to inflation risk. From the perspective of the lender, the purchasing power of provided cash flows might be subject to erosion in inflationary pressures. Inflation indexed bonds issued in a way that to hedge this risk and provide real return to the bond holder. UK issued first inflation indexed bonds as sovereign in 1981. Then, developed countries such as US, Canada, France, Germany, and emerging market countries such as Turkey, Brazil, Mexico had high interest in issuing these bonds. The principal and coupon payments of these bonds are linked to the changes in the reference price index. Inflation indexed bonds might be issued as plain, which excludes any protection against deflation. On the other hand, bonds might be issued with deflation protection (put) option embedded since bond cash flows will be less than the nominal value in a deflationary economic environment. Deflation protection might cover only principal value as in TIPS issued by US or both principal and coupon payments as inflation indexed bonds issued by Turkish Treasury. This thesis aims to price deflation protection option premium in Turkish bond market by decomposing bond structure into plain and option components. First, we review the Jarrow-Yildirim model under the HJM framework and the analytical formulas for derivative prices available in that model. Then, we use historical bond market data to estimate model parameters and the price of the embedded deflation protection option. Finally, we examine historical course of this premium for bonds with different characteristics and inflation expectations.

Subject Keywords

Bond Pricing, Debt Securities, Deflation Premium, Fixed Income Market, HJM Framework, Jarrow-Yildirim Model, Inflation Indexed Bonds

URI

https://hdl.handle.net/11511/69297

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Graduate School of Applied Mathematics, Thesis

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Citation Formats

B. Bayram, “Pricing inflation indexed bonds and embedded deflation floor options: An analysis on Turkish bond market,” M.S. - Master of Science, Middle East Technical University, 2020.