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Real and Nominal Interest Rates: A Discrete-Time Model and Its Continuous-Time Limit

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Author Info
Sun, Tong-sheng
Abstract

I provide a general equilibrium theory of the term structure of real interest rates in a discrete-time economy. I derive the prices for one-period and two-period real bonds and a simple recursive formula for general k-period bonds, and prove that the price formula with appropriately specified parameters converges to that of the Cox, Ingersoll, and Ross model (1985). In addition, I consider the behavior of nominal bond prices in a partial equilibrium setting in which an exogenous price level process is correlated with the real economy. Finally, I provide an illustrative empirical investigation of the model. The results indicate a significant correlation between the price level and the growth rate of consumption, which does not support the "money nuetrality" assumption underlying Cox, Ingersoll, and Ross's nominal bond prices and related empirical studies, such as Gibbons and Ramaswamyu (1992), Heston(1991), and Pearson and Sun (1991). Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Article provided by Oxford University Press for Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 5 (1992)
Issue (Month): 4 ()
Pages: 581-611
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Handle: RePEc:oup:rfinst:v:5:y:1992:i:4:p:581-611

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  1. Driffill, John & Kenc, Turalay & Sola, Martin & Spagnolo, Fabio, 2004. "On Model Selection and Markov Switching: A Empirical Examination of Term Structure Models with Regime Shifts," CEPR Discussion Papers 4165, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Marco Realdon, 2006. "The Target Rate and Term Structure of Interest Rates," Discussion Papers 06/15, Department of Economics, University of York. [Downloadable!]
  3. David G. Barr & John Y. Campbell, 1996. "Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices," NBER Working Papers 5821, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Frank Riedel, 1999. "Heterogeneous Time Preferences and Interest Rates - The Preferred Habitat Theory Revisited," Finance 9903001, EconWPA. [Downloadable!]
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  5. Andrew Ang & Geert Bekaert, 2004. "The term structure of real rates and expected inflation," Proceedings, Federal Reserve Bank of San Francisco, issue Mar. [Downloadable!]
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  6. David Backus & Silverio Foresi & Chris Telmer, 1998. "Discrete-Time Models of Bond Pricing," NBER Working Papers 6736, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Martin Evans, 1998. "Looking Behind the U. K.Term Structure: Were there Peso Problems in Inflation?," Finance 9809001, EconWPA. [Downloadable!]
  8. Frank F. Gong & Eli M. Remolona, 1996. "Two factors along the yield curve," Research Paper 9613, Federal Reserve Bank of New York. [Downloadable!]
  9. Fendel, Ralf, 2004. "Towards a Joint Characterization of Monetary Policy and the Dynamics of the Term Structure of Interest Rates," Discussion Paper Series 1: Economic Studies 2004,24, Deutsche Bundesbank, Research Centre. [Downloadable!]
  10. Marco Realdon, 2006. "Quadratic Term Structure Models in Discrete Time," Discussion Papers 06/01, Department of Economics, University of York. [Downloadable!]
  11. Wang, Jiang, 1959-, 1995. "The term structure of interest rates in a pure exchange economy with heterogeneous investors," Working papers 3839-95., Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
  12. David Backus & Silverio Foresi & Abon Mozumdar & Liuren Wu, 1998. "Predictable Changes in Yields and Forward Rates," NBER Working Papers 6379, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  13. John Y. Campbell & Luis M. Viceira, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March. [Downloadable!] (restricted)
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  14. Gurdip S. Bakshi & Zhiwu Chen, . "An Alternative Model for Contingent Claims," Research in Financial Economics 9504, Ohio State University. [Downloadable!]
  15. Joseph G. Haubrich, 1999. "Term structure economics from A to B," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 2-9. [Downloadable!]
  16. Joseph G. Haubrich, 2000. "Productivity and the term structure," Economic Review, Federal Reserve Bank of Cleveland, issue Q IV, pages 2-9. [Downloadable!]
  17. Silverio Foresi & Alessandro Penati & George Pennacchi, 1997. "Estimating the cost of U.S. indexed bonds," Working Paper 9701, Federal Reserve Bank of Cleveland. [Downloadable!]
  18. Jiang Wang, 1995. "The Term Structure of Interest Rates in a Pure Exchange Economy with Heterogeneous Investors," NBER Working Papers 5172, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  19. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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