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Arbitrage-free bond pricing with dynamic macroeconomic models

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Author Info

  • Michael F. Gallmeyer
  • Burton Hollifield
  • Francisco J. Palomino
  • Stanley E. Zin

Abstract

The authors examine the relationship between changes in short-term interest rates induced by monetary policy and the yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. The authors explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. They study the properties of the yield curve when inflation is an exogenous process and compare this with the yield curve when inflation is endogenous and determined through an interest rate (Taylor) rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult because the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation-a necessary condition for an upward-sloping yield curve, as shown in Backus and Zin. Endogenizing inflation provides a substantially better fit of the historical yield curve because the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities, which better fits historical bond data.

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Bibliographic Info

Article provided by Federal Reserve Bank of St. Louis in its journal Review.

Volume (Year): (2007)
Issue (Month): Jul ()
Pages: 305-326

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Handle: RePEc:fip:fedlrv:y:2007:i:jul:p:305-326:n:v.89no.4

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Keywords: Bonds - Prices ; Macroeconomics;

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References

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  1. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
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  15. Ravenna , Federico & Seppälä , Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Research Discussion Papers 25/2006, Bank of Finland.
  16. Michael Gallmeyer & Burton Hollifield & Stanley E. Zin, 2005. "Taylor Rules, McCallum Rules and the Term Structure of Interest Rates," NBER Working Papers 11276, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Andrew Atkeson & Patrick J. Kehoe, 2008. "On the need for a new approach to analyzing monetary policy," Working Papers 662, Federal Reserve Bank of Minneapolis.
  2. Chernov, Mikhail & Mueller, Philippe, 2008. "The Term Structure of Inflation Expectations," CEPR Discussion Papers 6809, C.E.P.R. Discussion Papers.
  3. Oreste Tristani & Gianni Amisano, 2010. "A nonlinear DSGE model of the term structure with regime shifts," 2010 Meeting Papers 234, Society for Economic Dynamics.
  4. John H. Cochrane, 2007. "Commentary on "Macroeconomic implications of changes in the term premium"," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 271-282.
  5. Bhamra, Harjoat S. & Fisher, Adlai J. & Kuehn, Lars-Alexander, 2011. "Monetary policy and corporate default," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 480-494.
  6. Gregory H. Bauer & Antonio Diez de los Rios, 2012. "An International Dynamic Term Structure Model with Economic Restrictions and Unspanned Risks," Working Papers 12-5, Bank of Canada.
  7. Backus, David & Chernov, Mikhail & Zin, Stanley E., 2011. "Sources of entropy in representative agent models," CEPR Discussion Papers 8488, C.E.P.R. Discussion Papers.
  8. Josephine M. Smith & John B. Taylor, 2007. "The Long and the Short End of the Term Structure of Policy Rules," NBER Working Papers 13635, National Bureau of Economic Research, Inc.
  9. Pamela Labadie, 2007. "Commentary on "Arbitrage-free bond pricing with dynamic macroeconomic models"," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 327-330.
  10. William T. Gavin & Benjamin D. Keen, 2012. "U.S. monetary policy: a view from macro theory," Working Papers 2012-019, Federal Reserve Bank of St. Louis.
  11. Gonzalez-Astudillo, Manuel, 2009. "An Equilibrium Model of the Term Structure of Interest Rates: Recursive Preferences at Play," MPRA Paper 19153, University Library of Munich, Germany.
  12. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
  13. Hasseltoft, Henrik, 2007. "The Long-run Risk Model: Dynamics and Cyclicality of Interest Rates," SIFR Research Report Series 58, Institute for Financial Research.
  14. Tanaka Hiroatsu, 2012. "Monetary Policy Regimes and the Term Structure of Interests Rates with Recursive Utility," 2012 Meeting Papers 557, Society for Economic Dynamics.
  15. Smith, Josephine M. & Taylor, John B., 2009. "The term structure of policy rules," Journal of Monetary Economics, Elsevier, vol. 56(7), pages 907-917, October.

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