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Uncovering Inflation Expectations and Risk Premiums From Internationally Integrated Financial Markets

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  • Fung, Ben
  • Mitnick, Scott
  • Remolona, Eli

Abstract

Theory and empirical evidence suggest that the term structure of interest rates reflects risk premiums as well as market expectations about future inflation and real interest rates. We propose an approach to extracting such premiums and expectations by exploiting both the comovements among interest rates across the yield curve and between two countries, Canada and the United States. This approach involves estimating a multi-factor affine-yield model jointly for the two countries, in which we identify a common factor as representing real rate expectations and two other factors as representing two separate inflation expectations for the two countries. To estimate the model, we apply a Kalman filter to monthly data on zero-coupon bond yields for 2-year, 5-year and 10-year maturities as well as inflation. Our estimates suggest that Canadian inflation expectations were slow to adjust to a new inflation-targeting regime. We also find inflation-risk premiums that vary between 10 and 90 basis points in the two countries, with U.S. bonds commanding smaller premiums.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 99-6.

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Length: 39 pages
Date of creation: 1999
Date of revision:
Handle: RePEc:bca:bocawp:99-6

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Related research

Keywords: Financial markets; Inflation and prices; Interest rates; International topics;

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References

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Citations

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Cited by:
  1. Martha Misas A. & Carlos Esteban Posada & Diego Mauricio Vásquez, 2001. "¿Está Determinado el Nivel de Precios por las Expectativas de Dinero y Producto en Colombia?," BORRADORES DE ECONOMIA 003807, BANCO DE LA REPÚBLICA.
  2. Bruno Feunou & Jean-Sébastien Fontaine, 2012. "Forecasting Inflation and the Inflation Risk Premiums Using Nominal Yields," Working Papers, Bank of Canada 12-37, Bank of Canada.
  3. Barros Luís, Jorge & Cassola, Nuno, 2001. "A two-factor model of the German term structure of interest rates," Working Paper Series, European Central Bank 0046, European Central Bank.
  4. James M. Nason & John H. Rogers, 2003. "The present-value model of the current account has been rejected: Round up the usual suspects," Working Paper, Federal Reserve Bank of Atlanta 2003-7, Federal Reserve Bank of Atlanta.
  5. David Jamieson Bolder, 2001. "Affine Term-Structure Models: Theory and Implementation," Working Papers, Bank of Canada 01-15, Bank of Canada.
  6. Gerald Stuber, 2001. "Implications of Uncertainty about Long-Run Inflation and the Price Level," Working Papers, Bank of Canada 01-16, Bank of Canada.

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