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Macro volatility in a model of the UK Gilt edged bond market

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  • Peter Spencer

    (University of York)

Abstract

This paper develops an arbitrage-free macroeconomic model of the yield curve and uses this to explain the behaviour of the UK Treasury bond market. Unlike previous models of this type, which assume a homoscedastic error process I develop a general affine model which allows volatility to be conditioned by the level of inflation (and possibly other macroeconomic variables). In my preferred empirical specification conditional volatility and risk premia are affine in the level of inflation. I test this model against more general specifications in which the risk premia also depend upon interest rate and other macro variables, but find little evidence of these wider effects. The resulting specification provides a parsimonious explanation of the behaviour of the UK yield curve, keying it in to the behaviour of the macroeconomy.

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File URL: http://repec.org/mmf2006/up.27010.1145382051.pdf
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Bibliographic Info

Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 73.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:73

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Web page: http://www.essex.ac.uk/afm/mmf/index.html

Related research

Keywords: Times series models; Affine term structure model; macroeconomic factors; monetary policy;

This paper has been announced in the following NEP Reports:

References

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  1. Hans Dewachter & Marco Lyrio, 2003. "Macro Factors and the Term Structure of Interest Rates," Center for Economic Studies - Discussion papers ces0304, Katholieke Universiteit Leuven, Centrum voor Economische Studiën.
  2. Grilli, Vittorio & Roubini, Nouriel, 1996. "Liquidity models in open economies: Theory and empirical evidence," European Economic Review, Elsevier, vol. 40(3-5), pages 847-859, April.
  3. Martin Lettau & Sydney C. Ludvigson, 2004. "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?," 2004 Meeting Papers 644, Society for Economic Dynamics.
  4. Holland, A Steven, 1995. "Inflation and Uncertainty: Tests for Temporal Ordering," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(3), pages 827-37, August.
  5. Francis X. Diebold & Glenn D. Rudebusch & S. Boragan Aruoba, 2003. "The macroeconomy and the yield curve: a nonstructural analysis," Working Paper Series 2003-18, Federal Reserve Bank of San Francisco.
  6. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
  7. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
  8. Kozicki, Sharon & Tinsley, P. A., 2001. "Shifting endpoints in the term structure of interest rates," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 613-652, June.
  9. Glenn Rudebusch, 2000. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Econometric Society World Congress 2000 Contributed Papers 0065, Econometric Society.
  10. Friedman, Milton, 1977. "Nobel Lecture: Inflation and Unemployment," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 451-72, June.
  11. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  12. repec:fip:fedfap:2003-17 is not listed on IDEAS
  13. Pearson, Neil D & Sun, Tong-Sheng, 1994. " Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model," Journal of Finance, American Finance Association, vol. 49(4), pages 1279-1304, September.
  14. Caporale, Tony & McKiernan, Barbara, 1997. "High and variable inflation: Further evidence on the Friedman hypothesis," Economics Letters, Elsevier, vol. 54(1), pages 65-68, January.
  15. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
  16. 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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