Extraction of financial market expectations about inflation and interest rates from a liquid market

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Extraction of financial market expectations about inflation and interest rates from a liquid market

Author Info

Ricardo Gimeno () (Banco de España)
José Manuel Marqués () (Banco de España)

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Abstract

In this paper we propose an affine model that uses as observed factors the Nelson and Siegel (NS) components summarising the term structure of interest rates. By doing so, we are able to reformulate the Diebold and Li (2006) approach to forecast the yield curve in a way that allows us to incorporate a non-arbitrage opportunities condition and risk aversion into the model. These conditions seem to improve the forecasting ability of the term structure components and provide us with an estimation of the risk premia. Our approach is somewhat equivalent to the recent contribution of Christiensen, Diebold and Rudebusch (2008). However, not only does it seem to be more intuitive and far easier to estimate, it also improves that model in terms of fitting and forecasting properties. Moreover, with this framework it is possible to incorporate directly the inflation rate as an additional factor without reducing the forecasting ability of the model. The augmented model produces an estimation of market expectations about inflation free of liquidity, counterparty and term premia. We provide a comparison of the properties of this indicator with others usually employed to proxy the inflation expectations, such as the break-even rate, inflation swaps and professional surveys.

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Paper provided by Banco de España in its series Banco de España Working Papers with number 0906.

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Length: 33 pages
Date of creation: Apr 2009
Date of revision:
Handle: RePEc:bde:wpaper:0906

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications

This paper has been announced in the following NEP Reports:

NEP-ALL-2009-04-13 (All new papers)
NEP-CBA-2009-04-13 (Central Banking)
NEP-ECM-2009-04-13 (Econometrics)
NEP-FMK-2009-04-13 (Financial Markets)
NEP-MAC-2009-04-13 (Macroeconomics)
NEP-MON-2009-04-13 (Monetary Economics)

References listed on IDEAS
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This page was last updated on 2009-11-10.

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