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A two-factor model of the German term structure of interest rates

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  • Barros Luís, Jorge
  • Cassola, Nuno
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    Abstract

    In this paper we show that a two-factor constant volatility model provides an adequate description of the dynamics and shape of the German term structure of interest rates from 1972 up to 1998. The model also provides reasonable estimates of the volatility and term premium curves. Following the conjecture that the two factors driving the German term structure of interest rates represent the H[-DQWH real interest rate and the expected inflation rate, the identification of one factor with expected inflation is discussed. Our estimates are obtained using a Kalman filter and a maximum likelihood procedure including in the measurement equation both the yields and their volatilities JEL Classification: E43, G12

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    Bibliographic Info

    Paper provided by European Central Bank in its series Working Paper Series with number 0046.

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    Date of creation: Mar 2001
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    Handle: RePEc:ecb:ecbwps:20010046

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    Related research

    Keywords: affine model; expectations hypothesis; pricing kernels; term premiums;

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    References

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    1. Mishkin, F.S., 1988. "What Does The Term Structure Tell Us About Future Inflation?," Papers fb-_88-29, Columbia - Graduate School of Business.
    2. Koedijk, Kees G & Kool, Clemens J M, 1995. "Future Inflation and the Information in International Term Structures," Empirical Economics, Springer, vol. 20(2), pages 217-42.
    3. Stefan Gerlach, 1995. "The information content of the term structure: evidence for Germany," BIS Working Papers 29, Bank for International Settlements.
    4. John Y. Campbell, 1995. "Some Lessons from the Yield Curve," Harvard Institute of Economic Research Working Papers 1713, Harvard - Institute of Economic Research.
    5. David K. Backus & Silverio Foresi & Chris Telmer, . "Discrete time models of bond pricing," GSIA Working Papers 251, Carnegie Mellon University, Tepper School of Business.
    6. Mishkin, Frederic S, 1990. "The Information in the Longer Maturity Term Structure about Future Inflation," The Quarterly Journal of Economics, MIT Press, vol. 105(3), pages 815-28, August.
    7. Backus, David & Foresi, Silverio & Mozumdar, Abon & Wu, Liuren, 2001. "Predictable changes in yields and forward rates," Journal of Financial Economics, Elsevier, vol. 59(3), pages 281-311, March.
    8. Jacobs, Mike & Remolona, Eli & Wickens, Michael R, 1998. "What was the Market's View of UK Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds," CEPR Discussion Papers 2022, C.E.P.R. Discussion Papers.
    9. Frederic S. Mishkin, 1991. "A Multi-Country Study of the Information in the Term Structure about Future Inflation," NBER Working Papers 3125, National Bureau of Economic Research, Inc.
    10. Robert R. Bliss, 1997. "Movements in the term structure of interest rates," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 16-33.
    11. Michael J. Fleming & Eli M Remolona, 1999. "The term structure of announcement effects," BIS Working Papers 71, Bank for International Settlements.
    12. Philippe Jorion & Frederic Mishkin, 1991. "A Multi-Country Comparison of Term Structure Forecasts at Long Horizons," NBER Working Papers 3574, National Bureau of Economic Research, Inc.
    13. Geyer, Alois L J & Pichler, Stefan, 1999. "A State-Space Approach to Estimate and Test Multifactor Cox-Ingersoll-Ross Models of the Term Structure," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 22(1), pages 107-30, Spring.
    14. Harvey,Andrew C., 1991. "Forecasting, Structural Time Series Models and the Kalman Filter," Cambridge Books, Cambridge University Press, number 9780521405737.
    15. Mishkin, Frederic S., 1991. "A multi-country study of the information in the shorter maturity term structure about future inflation," Journal of International Money and Finance, Elsevier, vol. 10(1), pages 2-22, March.
    16. Fama, Eugene F., 1990. "Term-structure forecasts of interest rates, inflation and real returns," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 59-76, January.
    17. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    18. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
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    Cited by:
    1. Viktors Ajevskis & Kristine Vitola, 2006. "A Factor Model of the Term Structure of Interest Rates and Risk Premium Estimation for Latvia's Money Market," Working Papers 2006/01, Latvijas Banka.
    2. Pilegaard, Rasmus & Durré, Alain & Evjen, Snorre, 2003. "Estimating risk premia in money market rates," Working Paper Series 0221, European Central Bank.
    3. De Rossi, Giuliano, 2004. "Kalman filtering of consistent forward rate curves: a tool to estimate and model dynamically the term structure," Journal of Empirical Finance, Elsevier, vol. 11(2), pages 277-308, March.

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