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A global model of international yield curves: no-arbitrage term structure approach

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  • Kaminska, Iryna

    ()
    (Bank of England)

  • Meldrum, Andrew

    ()
    (University of Cambridge)

  • Smith, James

    ()
    (Bank of England)

Abstract

This paper extends a popular no-arbitrage affine term structure model to model jointly bond markets and exchange rates across the United Kingdom, United States and euro area. Using a monthly data set of forward rates from 1992, we first demonstrate that two global factors account for a significant proportion in the variation of bond yields across countries. We also show that, in order to explain country-specific movements in yield curves, local factors are required. Although we implement a very general factor structure, we find that our global factors are related to global inflation and global economic activity, while local factors are closely linked to monetary policy rates. In this respect our results are similar to previous work. But an important advantage of our joint international model is that we are able to decompose interest rates into risk-free rates and risk premia. Additionally, we are able to study the implications for exchange rates. We show that while differences in risk-free rates matter, to a large extent changes in the exchange rate are determined by time-varying exchange rate risk premia.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 419.

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Length: 37 pages
Date of creation: 12 Apr 2011
Date of revision:
Handle: RePEc:boe:boeewp:0419

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Keywords: Term structure models; exchange rates.;

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  1. Peter Hoerdahl & Oreste Tristani, 2007. "Inflation risk premia in the term structure of interest rates," BIS Working Papers 228, Bank for International Settlements.
  2. Diebold, Francis X. & Li, Canlin & Yue, Vivian Z., 2008. "Global yield curve dynamics and interactions: A dynamic Nelson-Siegel approach," Journal of Econometrics, Elsevier, vol. 146(2), pages 351-363, October.
  3. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  4. Joyce, Michael & Lildholdt, Peter & Sorensen, Steffen, 2009. "Extracting inflation expectations and inflation risk premia from the term structure: a joint model of the UK nominal and real yield curves," Bank of England working papers 360, Bank of England.
  5. Antonio Diez de los Rios, 2006. "Can Affine Term Structure Models Help Us Predict Exchange Rates?," Working Papers 06-27, Bank of Canada.
  6. Geert Bekaert & Min Wei & Yuhang Xing, 2002. "Uncovered Interest Rate Parity and the Term Structure," NBER Working Papers 8795, National Bureau of Economic Research, Inc.
  7. Joyce, Michael & Kaminska, Iryna & Lildholdt, Peter, 2008. "Understanding the real rate conundrum: an application of no-arbitrage finance models to the UK real yield curve," Bank of England working papers 358, Bank of England.
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