Prices Are More Than Expectations
This week I came across this tweet by @NewRiverInvest:
Breakevens are not inflation expectations (thread)
It explains how implied breakevens from TIPs are not the same as inflation expectations. One of the reasons is because it’s a small market that is easily distorted.
The second reason is more technical. TIPs are actually implicit options. The face value increases with inflation but is floored at par. So if we experienced deflation you’d get your now-even-more valuable USD back. We should presume the TIPs price reflects not just inflation expectations but a premium for the option value.
This is a familiar lesson. Think about volatility risk premiums. Since convexity improves portfolio CAGRs the expected value of owning an option should actually be negative in arithmetic terms. This is why quants will fancily say “implied vol is a biased estimator of realized vol.” It’s overpriced on average but it’s correlation and convexity attributes suggest it is not overpriced in a repeated, compounding framework.
Another demonstration of “price does not equal expectation” is found in correlation itself. Correlation swaps trade at cheaper levels than implied correlation because being short correlation is a concave (ie negatively convex) position. A correlation seller will require an additional risk premia to be short it. A further explanation can be found in my notes.
So whenever you imply an expectation from a price you need to strip out any additional risk premia or preference that is embedded in the price.
This ties in well with Why You Don’t Get Paid For Diversifiable Risks (MoontowerMeta)