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Reverse Engineering the Yield Curve

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  • David K. Backus
  • Stanley E. Zin

Abstract

Prices of riskfree bonds in any arbitrage-free environment are governed by a pricing kernel: given a kernel, we can compute prices of bonds of any maturity we like. We use observed prices of multi-period bonds to estimate, in a log-linear theoretical setting, the pricing kernel that gave rise to them. The high-order dynamics of our estimated kernel help to explain why first-order, one-factor models of the term structure have had difficulty reconciling the shape of the yield curve with the persistence of the short rate. We use the estimated kernel to provide a new perspective on Hansen-Jagannathan bounds, the price of risk, and the pricing of bond options and futures.

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Bibliographic Info

Paper provided by New York University, Leonard N. Stern School of Business, Department of Economics in its series Working Papers with number 94-09.

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Date of creation: 1994
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Handle: RePEc:ste:nystbu:94-09

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Postal: New York University, Leonard N. Stern School of Business, Department of Economics, 44 West 4th Street, New York, NY 10012-1126
Phone: (212) 998-0860
Fax: (212) 995-4218
Web page: http://w4.stern.nyu.edu/economics/
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References

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  7. Gallant, A.R. & Tauchen, G., 1988. "Seminonparametric Estimation Of Conditionally Constrained Heterogeneous Processes: Asset Pricing Applications," Papers 88-59, Chicago - Graduate School of Business.
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  21. Jamshidian, Farshid, 1989. " An Exact Bond Option Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 205-09, March.
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  1. Recursive Macroeconomic Theory
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