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An estimate of the inflation risk premium using a three-factor affine term structure model

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  • J. Benson Durham

Abstract

This paper decomposes nominal Treasury yields into expected real rates, expected inflation rates, real risk premiums, and inflation risk premiums by separately calibrating a three-factor affine term structure model to the nominal Treasury and TIPS yield curves. Although this particular application seems to produce expected real short rates and inflation rates that are somewhat static, there are theoretical advantages to calibrating the model to nominal and real yields separately. Moreover, the estimates correlate positively with back-of-the-envelope measures of the inflation risk premium. With respect to the current environment, monetary policy uncertainty does not seem to have contributed to the apparent increase in the inflation risk premium since the beginning of 2006. Also, in purely nominal terms, the increase in term premiums thus far this year might be just as much a global as a domestic phenomenon, given that nominal term premiums have also increased in Germany and the United Kingdom.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2006-42.

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Date of creation: 2006
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Handle: RePEc:fip:fedgfe:2006-42

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Keywords: Inflation risk ; Inflation (Finance) ; Econometric models;

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References

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  1. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," Cowles Foundation Discussion Papers 1125, Cowles Foundation for Research in Economics, Yale University.
  2. Das, Sanjiv R., 2002. "The surprise element: jumps in interest rates," Journal of Econometrics, Elsevier, vol. 106(1), pages 27-65, January.
  3. 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.
  4. Kandel, Shmuel & Ofer, Aharon R & Sarig, Oded, 1996. " Real Interest Rates and Inflation: An Ex-Ante Empirical Analysis," Journal of Finance, American Finance Association, vol. 51(1), pages 205-25, March.
  5. Don H. Kim & Athanasios Orphanides, 2005. "Term structure estimation with survey data on interest rate forecasts," Finance and Economics Discussion Series 2005-48, Board of Governors of the Federal Reserve System (U.S.).
  6. Zvi Bodie, 1979. "Inflation Risk and Capital Market Equilibrium," NBER Working Papers 0373, National Bureau of Economic Research, Inc.
  7. Ho, Thomas S Y & Lee, Sang-bin, 1986. " Term Structure Movements and Pricing Interest Rate Contingent Claims," Journal of Finance, American Finance Association, vol. 41(5), pages 1011-29, December.
  8. Monika Piazzesi, 2005. "Bond Yields and the Federal Reserve," Journal of Political Economy, University of Chicago Press, vol. 113(2), pages 311-344, April.
  9. Langetieg, Terence C, 1980. " A Multivariate Model of the Term Structure," Journal of Finance, American Finance Association, vol. 35(1), pages 71-97, March.
  10. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Data," Harvard Institute of Economic Research Working Papers 1758, Harvard - Institute of Economic Research.
  11. Don H. Kim & Jonathan H. Wright, 2005. "An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates," Finance and Economics Discussion Series 2005-33, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:
  1. Tobias Adrian & Hao Wu, 2009. "The term structure of inflation expectations," Staff Reports 362, Federal Reserve Bank of New York.
  2. Brière, Marie & Signori, Ombretta, 2009. "Do Inflation-Linked Bonds Still Diversify ?," Economics Papers from University Paris Dauphine 123456789/7741, Paris Dauphine University.
  3. J. Benson Durham, 2007. "Implied interest rate skew, term premiums, and the "conundrum"," Finance and Economics Discussion Series 2007-55, Board of Governors of the Federal Reserve System (U.S.).
  4. Peter Hördahl, 2008. "The inflation risk premium in the term structure of interest rates," BIS Quarterly Review, Bank for International Settlements, September.
  5. Christophe, Faugere, 2003. "A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination," MPRA Paper 15579, University Library of Munich, Germany, revised 04 Jun 2009.
  6. Joshua V. Rosenberg & Samuel Maurer, 2008. "Signal or noise? Implications of the term premium for recession forecasting," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 1-11.
  7. Flávio de Freitas Val & Claudio Henrique da Silveira Barbedo & Marcelo Verdini Maia, 2011. "Inflation expectation and implicit inflation: does market research provide accurate measures?," Brazilian Business Review, Fucape Business School, vol. 8(3), pages 83-100, July.

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