The impact of indexed bonds on capital market Equilibrium

Abstract

This paper derives an equilibrium capital asset pricing model with uncertain inflation. of which the Sharpe-Lintner-Mossin and the Roll models are the special cases. Based upon the comparison of two capital market equilibria, one with inflation-indexed bonds and the other one without, we analyze 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 bond to the price level per se results in welfare gain in risk-reduction in the capital markets It is shown 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. Some hypotheses from our model can be used to test empirically the effects of the recent introduction of TlPS in the U.S.