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Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models

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Author Info
Michael F. Gallmeyer
Burton Hollifield
Francisco Palomino
Stanley E. Zin

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Abstract

We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. We study the properties of the yield curve when inflation is an exogenous process and compare this to the yield curve when inflation is endogenous and determined through an interest-rate/Taylor rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult as the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation - a necessary condition for an upward sloping yield curve as shown in Backus and Zin (1994). Endogenizing inflation provides a substantially better fit of the historical yield curve as the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities which better fits historical bond data.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13245.

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Date of creation: Jul 2007
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Handle: RePEc:nbr:nberwo:13245

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E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
G0 - Financial Economics - - General
G1 - Financial Economics - - General Financial Markets

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  4. Geert Bekaert & Seonghoon Cho & Antonio Moreno, 2005. "New-Keynesian Macroeconomics and the Term Structure," NBER Working Papers 11340, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, 02. [Downloadable!] (restricted)
  6. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May. [Downloadable!] (restricted)
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  7. Gallmeyer, Michael F. & Hollifield, Burton & Zin, Stanley E., 2005. "Taylor rules, McCallum rules and the term structure of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(5), pages 921-950, July. [Downloadable!] (restricted)
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  8. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  9. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July. [Downloadable!] (restricted)
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  12. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08. [Downloadable!] (restricted)
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  13. Evans, Charles L. & Marshall, David A., 1998. "Monetary policy and the term structure of nominal interest rates: Evidence and theory," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 53-111, December. [Downloadable!] (restricted)
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  14. Ravenna , Federico & Seppälä , Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Research Discussion Papers 25/2006, Bank of Finland. [Downloadable!]
  15. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Monika Piazzesi, 2005. "Bond Yields and the Federal Reserve," Journal of Political Economy, University of Chicago Press, vol. 113(2), pages 311-344, April.
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  18. Monika Piazzesi & Martin Schneider, 2006. "Equilibrium Yield Curves," NBER Working Papers 12609, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  19. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Pamela Labadie, 2007. "Commentary on "Arbitrage-free bond pricing with dynamic macroeconomic models"," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 327-330. [Downloadable!]
  2. Andrew Atkeson & Patrick J. Kehoe, 2008. "On the need for a new approach to analyzing monetary policy," Working Papers 662, Federal Reserve Bank of Minneapolis. [Downloadable!]
    Other versions:
  3. Hasseltoft, Henrik, 2007. "The Long-run Risk Model: Dynamics and Cyclicality of Interest Rates," SIFR Research Report Series 58, Institute for Financial Research. [Downloadable!]
  4. John H. Cochrane, 2007. "Commentary on "Macroeconomic implications of changes in the term premium"," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 271-282. [Downloadable!]
  5. Josephine M. Smith & John B. Taylor, 2007. "The Long and the Short End of the Term Structure of Policy Rules," NBER Working Papers 13635, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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