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

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  • Ricardo Gimeno

    ()
    (Banco de España)

  • José Manuel Marqués

    ()
    (Banco de España)

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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File URL: http://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/09/Fic/dt0906e.pdf
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Bibliographic Info

Paper provided by Banco de Espa�a in its series Banco de Espa�a 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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Keywords: Interest Rate Forecast; Inflation Expectations; Affine Model; Diebold and Li;

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  1. Kim, Don H. & Orphanides, Athanasios, 2012. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 47(01), pages 241-272, February.
  2. Thomas Laubach and John C. Williams, 2001. "Measuring the Natural Rate of Interest," Computing in Economics and Finance 2001, Society for Computational Economics 35, Society for Computational Economics.
  3. Christensen, Jens H.E. & Diebold, Francis X. & Rudebusch, Glenn D., 2011. "The affine arbitrage-free class of Nelson-Siegel term structure models," Journal of Econometrics, Elsevier, Elsevier, vol. 164(1), pages 4-20, September.
  4. Adjemian, Stéphane & Darracq Pariès, Matthieu & Smets, Frank, 2008. "A quantitative perspective on optimal monetary policy cooperation between the US and the euro area," Working Paper Series, European Central Bank 0884, European Central Bank.
  5. Hans Dewachter & Marco Lyrio & Konstantijn Maes, 2001. "A Joint Model for the Term Structure of Interest Rates and the Macroeconomy," International Economics Working Papers Series, Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics wpie002, Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics.
  6. Wu, Tao, 2006. "Macro Factors and the Affine Term Structure of Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 38(7), pages 1847-1875, October.
  7. Iryna Kaminska & Andrea Carriero & Carlo A. Favero, 2004. "Financial Factors, Macroeconomic Information and the Expectations Theory of the Term Structure of Interest Rates," Computing in Economics and Finance 2004, Society for Computational Economics 76, Society for Computational Economics.
  8. Diebold, Francis X. & Li, Canlin, 2006. "Forecasting the term structure of government bond yields," Journal of Econometrics, Elsevier, Elsevier, vol. 130(2), pages 337-364, February.
  9. Jorion, Philippe & Mishkin, Frederic, 1991. "A multicountry comparison of term-structure forecasts at long horizons," Journal of Financial Economics, Elsevier, Elsevier, vol. 29(1), pages 59-80, March.
  10. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, American Finance Association, vol. 55(5), pages 1943-1978, October.
  11. Geert Bekaert & Robert J. Hodrick, 2000. "Expectations Hypotheses Tests," NBER Working Papers 7609, National Bureau of Economic Research, Inc.
  12. Andrew Ang & Geert Bekaert, 2004. "The term structure of real rates and expected inflation," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
  13. Hans Dewachter & Marco Lyrio, 2002. "Macro Factors and the Term Structure of Interest Rates," International Economics Working Papers Series, Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics wpie007, Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics.
  14. Gimeno, Ricardo & Nave, Juan M., 2009. "A genetic algorithm estimation of the term structure of interest rates," Computational Statistics & Data Analysis, Elsevier, Elsevier, vol. 53(6), pages 2236-2250, April.
  15. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(4), pages 745-787, May.
  16. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 177-188, November.
  17. Andrew Ang & Geert Bekaert & Min Wei, 2006. "Do macro variables, asset markets, or surveys forecast inflation better?," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2006-15, Board of Governors of the Federal Reserve System (U.S.).
  18. Ricardo Gimeno & José Manuel Marqués, 2008. "Uncertainty and the price of risk in a nominal convergence process," Banco de Espa�a Working Papers, Banco de Espa�a 0802, Banco de Espa�a.
  19. Estrella, Arturo & Mishkin, Frederic S., 1997. "The predictive power of the term structure of interest rates in Europe and the United States: Implications for the European Central Bank," European Economic Review, Elsevier, Elsevier, vol. 41(7), pages 1375-1401, July.
  20. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 385-407, March.
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