Deflation Risk

Matthias Fleckenstein; Francis A. Longstaff; Hanno Lustig

doi:10.1093/rfs/hhx021

Deflation Risk

Matthias Fleckenstein¹; Francis A. Longstaff²; Hanno Lustig³

¹ Lerner College of Business and Economics, University of Delaware · ² UCLA Anderson School of Management and NBER () · ³ Graduate School of Management, Stanford University and NBER

Review of Financial Studies 2017

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5% over the next 30 years. Despite this, the market places substantial weight on deflation scenarios in which prices significantly decline over extended horizons. The market prices the economic tail risk of deflation similarly to other types of tail risks, such as corporate default or catastrophic insurance losses. We find that deflation risk is strongly negatively correlated with outcomes in the financial markets and with consumer confidence. Received January 26, 2015; editorial decision November 14, 2016 by Editor Leonid Kogan.

DOI: 10.1093/rfs/hhx021
Volume: 30 (8)
Pages: 2719-2760
Language: en
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