Published Papers

Matthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig. 

"Deflation Risk.", 2017, The Review of Financial Studies, 30: 2719-2760.

doi: 10.1093/rfs/hhx021


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.



Matthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig. 

"The TIPS-Treasury Bond Puzzle.", 2014, The Journal of Finance, 69: 2151–2197. doi: 10.1111/jofi.12032



We show that the price of a Treasury bond and an inflation-swapped TIPS issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS–Treasury mispricing has exceeded $56 billion, representing nearly 8% of the total amount of TIPS outstanding. We find direct evidence that the mispricing narrows as additional capital flows into the markets. This provides strong support for the slow-moving-capital explanation of the persistence of arbitrage.



Working Papers

Matthias Fleckenstein, Francis A. Longstaff.  (September 2017)

"Shadow Funding Cost: Measuring the Cost of Balance Sheet Constraints."



Recent theory suggests that balance sheet frictions and constraints faced by financial intermediaries can have major asset pricing implications. We propose a new measure of the impact of these constraints on intermediaries’ funding costs that is based on the implied cost of renting intermediaries’ balance sheet space. On average, balance sheet constraints add 81 basis points to intermediary funding costs, but the impact often exceeds 200 basis points during a crisis. We find that these balance sheet costs have real effects on intermediary investment decisions and asset holdings. Increases in balance sheet costs are associated with short-term increases in the use of derivatives, but longer-term declines in risktaking by financial institutions. Balance sheet costs introduce a wedge between on- and off-balance-sheet investments which may help resolve a number of asset pricing puzzles.



Matthias Fleckenstein, Pengjie Gao, Priyank Gandhi. (November 2017)

"Tax Policy Uncertainty and Asset Prices: Evidence from Dual-class Corporate Bonds in the Early 20th Century."



In the early 1900's, many U.S. corporations issued dual-class bonds that had almost identical cash flow and discount rate profiles, but differed in their tax-exemption status. Using a simple model, we derive an empirical measure of tax policy uncertainty from this unique set of financial instruments. We then examine the properties of tax policy uncertainty during the turbulent period immediately after the introduction of the first federal income taxes in the U.S. We also study if tax policy uncertainty is priced in the cross-section of asset returns. We find that tax policy uncertainty demands a pro-cyclical and statistically significant risk premium of -1.4% per year. Our study provides novel evidence that suggests taxes affect asset prices not only through its level but also via tax policy uncertainty itself.



Matthias Fleckenstein, Martijn Cremers, Priyank Gandhi. (November 2017)

"Treasury Yield Implied Volatility and Real Activity."



The level of at-the-money implied volatility from Treasury derivatives market (Treasury ‘yield implied volatility’) predicts the level and volatility of macroeconomic activity such as the growth rates of GDP, industrial production, consumption, and employment. This predictability is robust to the inclusion of several popular forecasting variables used in the literature. Treasury yield implied volatility – a proxy for interest rate uncertainty – thus constitutes a useful forward-looking state variable that characterizes risks and opportunities in the macroeconomy. We study one potential explanation for these results: Banks’ exposure to interest rate uncertainty. An increase in Treasury yield implied volatility increases interest rate uncertainty and adversely impacts bank deposits, bank credit growth, and banks’ cost of capital. Consistent with this mechanism, impact of Treasury yield implied volatility on banks’ in creases in their exposure to interest rate risk.



Matthias Fleckenstein (March 2016)

"The Term Structure of Interest Rates and Inflation Derivatives."




Matthias Fleckenstein. (April 2013).

"The Inflation-Indexed Bond Puzzle."



This paper presents new insights into the dynamics and determinants of arbitrage mispricing in and across seven of the world’s largest and most liquid financial markets. Specifically, this paper analyzes mispricing between nominal and inflation-linked bonds (ILB mispricing) in the G7 government bond markets, and extends the slow moving capital explanation of the persistence of arbitrage mispricing in financial markets. Nominal bonds are “richer” than cash-flow matched inflation-linked bonds on average. The mispricing is stunning in magnitude: aggregate mispricing is in excess of 22 billion on average during the period from July 2004 to September 2011. In the aftermath of the 2008 financial crisis, it peaks at 101 billion which represents more than eight percent of the total size of the G7 inflation-linked bond markets. Furthermore, the index-linked–nominal bond trade generates positively-skewed risk-adjusted excess returns across all countries, refuting the notion that the arbitrage trade is just picking up nickels in front of a steamroller. The key new insight for the slow-moving capital theory is that capital available to specific types of arbitrageurs is significantly related to the inflation-linked–nominal bond mispricing. Specifically, returns of hedge funds following fixed income strategies strongly predict subsequent changes in ILB mispricing, whereas other hedge fund categories lack statistically significant forecasting power. This paper also presents new insights into the effects of monetary policy on arbitrage mispricing. Specifically, during the 2008 financial crisis, central banks around the world may have exacerbated ILB mispricing through large-scale asset purchase programs.



Matthias Fleckenstein. (Sept 2012)

A Robust Explanation of the Forward Premium Puzzle and the Failure of the Expectation Hypothesis in Bond Markets."



This paper presents a continuous-time endowment economy model that can explain the uncovered interest rate parity (UIP) puzzle in foreign exchange markets and the failure of the expectations hypothesis (EH) in bond markets. The representative agent is endowed with a reference model of the economy. However, she takes into account the possibility that her reference model might be incorrect and tries to hedge against model misspecification errors by considering a set of models that are observationally close to each other. The model endogenously generates countercyclical real interest rates and an upward sloping real yield curve. The slope coefficients in UIP and EH regressions are negative. Furthermore, the model matches the level and volatility of the equity premium, consumption growth, the riskfree interest rate, and exchange rates.





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