Ok, so we learned that Internet stock prices don’t reflect their true value. We learned that house prices don’t reflect their true value. We learned that Greek bonds prices didn’t reflect their true value.

Yet somehow we keep believing that markets prices are rational. Prices are just prices.

]]>Regarding the modeling of inflation caps & floors, if you choose to model inflation rates directly, as per term sheets, then you need to use something like a normal model that allows negative rates. It is often convenient to model the price index instead, since that allows lognormal-type models. In a lognormal setup, you typically find that caps & floors trade with pronounced skews.

]]>You must still believe the market is rational and efficient. I see the treasury market as dominated by ‘automatic’ and irrational buying by sovereigns, and retirement funds and so forth, not to mention our own Fed. Even Pimco is a small fish in those waters and does not set prices.

I see treasury yields as a measure of demand by so many nations for treasuries, and nothing more.

]]>Otherwise, TIPS are just telling us the same thing that the rest of the bond market is telling us — investment returns are expected to be pretty crappy over the next five years.

]]>However, you’ve got the details wrong. All cashflows in the bond are multiplied by the growth of the price index I(t) from base date 0 to cashflow date t; in other words, by I(t)/I(0). When deflation occurs, this multiplier is less than one, but it stays positive because I is strictly positive. The multiplier is not adjusted for coupons, so the actual coupon paid can be less than the nominal rate, but never zero.

However, the ratio I(T)/I(0) is floored at 1 when applied to the principal; this is equivalent to a floor on the inflation rate at zero.

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