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Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves

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Author Info

  • Joyce, Michael A.S.
  • Lildholdt, Peter
  • Sorensen, Steffen

Abstract

This paper analyses the UK interest rate term structure over the period since October 1992, when the United Kingdom adopted an explicit inflation target, using an affine term structure model estimated using both government bond yields and survey data. The model imposes no-arbitrage restrictions across nominal and real yields, which enables interest rates to be decomposed into expected real policy rates, expected inflation, real term premia and inflation risk premia. The model is used to shed light on major developments over the period, including the impact of Bank of England independence and the low real bond yield 'conundrum'.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 34 (2010)
Issue (Month): 2 (February)
Pages: 281-294

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Handle: RePEc:eee:jbfina:v:34:y:2010:i:2:p:281-294

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

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Keywords: Inflation expectations Inflation risk premia Affine term structure model;

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References

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  1. Pennacchi, George G, 1991. "Identifying the Dynamics of Real Interest Rates and Inflation: Evidence Using Survey Data," Review of Financial Studies, Society for Financial Studies, vol. 4(1), pages 53-86.
  2. Peter Lildholdt & Nikolaos Panigirtzoglou & Chris Peacock, 2007. "An affine macro-factor model of the UK yield curve," Bank of England working papers 322, Bank of England.
  3. Wright, Jonathan H. & Zhou, Hao, 2009. "Bond risk premia and realized jump risk," Journal of Banking & Finance, Elsevier, vol. 33(12), pages 2333-2345, December.
  4. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  5. de Jong, Frank, 2000. "Time Series and Cross-Section Information in Affine Term-Structure Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 18(3), pages 300-314, July.
  6. Jacobs, Mike & Remolona, Eli & Wickens, Michael R, 1998. "What was the Market's View of UK Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds," CEPR Discussion Papers 2022, C.E.P.R. Discussion Papers.
  7. Don H. Kim & Athanasios Orphanides, 2005. "Term structure estimation with survey data on interest rate forecasts," Finance and Economics Discussion Series 2005-48, Board of Governors of the Federal Reserve System (U.S.).
  8. Sharon Kozicki & P.A. Tinsley, 1997. "Shifting endpoints in the term structure of interest rates," Research Working Paper 97-08, Federal Reserve Bank of Kansas City.
  9. Almeida, Caio & Vicente, José, 2008. "The role of no-arbitrage on forecasting: Lessons from a parametric term structure model," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2695-2705, December.
  10. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
  11. Martin Evans, 2002. "Real Risk, Inflation Risk, and the Term Structure," Working Papers gueconwpa~02-02-10, Georgetown University, Department of Economics.
  12. Don H. Kim & Jonathan H. Wright, 2005. "An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates," Finance and Economics Discussion Series 2005-33, Board of Governors of the Federal Reserve System (U.S.).
  13. Nicola Anderson & John Sleath, 2001. "New estimates of the UK real and nominal yield curves," Bank of England working papers 126, Bank of England.
  14. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
  15. Chiona Balfoussia & Michael Wickens, 2004. "Macroeconomic Sources of Risk in the Term Structure," CESifo Working Paper Series 1329, CESifo Group Munich.
  16. Brian Sack & Robert Elsasser, 2004. "Treasury inflation-indexed debt: a review of the U.S. experience," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 47-63.
  17. Joyce, Michael & Kaminska, Iryna & Lildholdt, Peter, 2008. "Understanding the real rate conundrum: an application of no-arbitrage finance models to the UK real yield curve," Bank of England working papers 358, Bank of England.
  18. Martin D. D. Evans, 1998. "Real Rates, Expected Inflation, and Inflation Risk Premia," Journal of Finance, American Finance Association, vol. 53(1), pages 187-218, 02.
  19. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  20. Kanas, Angelos, 2008. "On real interest rate dynamics and regime switching," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2089-2098, October.
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