An Analysis of the Determinants of Inflation-linked Bond Prices in Korea

Abstract

We estimate term structure using Korean financial data such as nominal spot rates, monthly inflation rates, and a survey of inflation forecasts, and examine the factors affecting Korean inflation-linked bond prices. Inflation-linked bond market yields are higher than the model yields generated using the term structure and the market-model yield differential is explained by the expected inflation rate, on-the-run/off-the-run spread, trading volume, and bond fund cash flows. This shows that inflation-linked bond investors understand the additional benefit of the tax exemption on the notional amount increment caused by inflation that the term structure model ignores, and the inflation-linked bond price is also affected by liquidity and supply–demand pressure.