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Pricing the term structure of inflation risk premia: Theory and evidence from TIPS

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  • Chen, Ren-Raw
  • Liu, Bo
  • Cheng, Xiaolin
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    Abstract

    In this paper, we study inflation risk and the term structure of inflation risk premia in the United States' nominal interest rates through the Treasury Inflation Protection Securities (TIPS) with a multi-factor, modified quadratic term structure model with correlated real and inflation rates. We derive closed form solutions to the real and nominal term structures of interest rates that drastically facilitate the estimation of model parameters and improve the accuracy of the valuation of nominal rates and TIPS prices. In addition, we contribute to the literature by estimating the term structure of inflation risk premia implied from the TIPS market. The empirical evidence using data from the period of January 1998 through October 2007 indicates that the expected inflation rate, contrary to data derived from the consumer price indices, is very stable and the inflation risk premia exhibit a positive term structure.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Empirical Finance.

    Volume (Year): 17 (2010)
    Issue (Month): 4 (September)
    Pages: 702-721

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    Handle: RePEc:eee:empfin:v:17:y:2010:i:4:p:702-721

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    Web page: http://www.elsevier.com/locate/jempfin

    Related research

    Keywords: Quadratic term structure model of interest rates TIPS Unscented Kalman filter Inflation risk premium;

    References

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    Cited by:
    1. Matthias Fleckenstein & Francis A. Longstaff & Hanno Lustig, 2013. "Deflation Risk," NBER Working Papers 19238, National Bureau of Economic Research, Inc.

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