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Abstract
We apply risk-neutral valuation to price TIPS bonds issued by the U.S. Treasury, paying close attention to an option embedded in these bonds that guaranties that bondholders are not affected by deflation. The value of this option is assumed to be trivial in the extant literature. We use a numerical simulation to show that the option value is nontrivial. We also consider the elasticity of TIPS bonds with respect to the real rate and the nominal rate and compare it to the Macaulay duration. An empirical test provides strong support for the adjustment suggested by our model for the elasticity of TIPS bonds.
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