Management of indexed government debt: Assessing the case for an inflation-indexed bond

Since The US Treasury's issuance of the inflation-protection securities (TIPS) in January 1997, there has been a great deal of renewed interest in studying various aspects of inflation-indexed bonds. This paper develops an equilibrium capital asset pricing model with uncertain inflation (CAPMUI), of which the Sharpe-Lintner-Mossin and the Roll models are the special cases. Based upon the CAPMUI, we analyse the impact of introducing inflation-indexed bonds on the risk-return relationships in the capital markets. Our analysis indicates that there is no a priori reason to believe that linking the bonds to the price level per se results in a welfare gain in risk-reduction in the capital markets. Our analysis indicates that a non-positive correlation between the return on the market portfolio and the rate of inflation is a sufficient condition for the introduction of indexed bonds to provide welfare gain in risk-reduction in the capital markets.