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Uncovering Inflation Expectations and Risk Premiums From Internationally Integrated Financial Markets


  • Fung, Ben
  • Mitnick, Scott
  • Remolona, Eli


Theory and empirical evidence suggest that the term structure of interest rates reflects risk premiums as well as market expectations about future inflation and real interest rates. We propose an approach to extracting such premiums and expectations by exploiting both the comovements among interest rates across the yield curve and between two countries, Canada and the United States. This approach involves estimating a multi-factor affine-yield model jointly for the two countries, in which we identify a common factor as representing real rate expectations and two other factors as representing two separate inflation expectations for the two countries. To estimate the model, we apply a Kalman filter to monthly data on zero-coupon bond yields for 2-year, 5-year and 10-year maturities as well as inflation. Our estimates suggest that Canadian inflation expectations were slow to adjust to a new inflation-targeting regime. We also find inflation-risk premiums that vary between 10 and 90 basis points in the two countries, with U.S. bonds commanding smaller premiums.

Suggested Citation

  • Fung, Ben & Mitnick, Scott & Remolona, Eli, 1999. "Uncovering Inflation Expectations and Risk Premiums From Internationally Integrated Financial Markets," Staff Working Papers 99-6, Bank of Canada.
  • Handle: RePEc:bca:bocawp:99-6

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    Cited by:

    1. Martha Misas A. & Carlos Esteban Posada P & Diego Mauricio Vásquez E, 2003. "¿Está determinado el nivel de precios por las expectativas de dinero y producto en Colombia?," Ensayos sobre Política Económica, Banco de la Republica de Colombia, vol. 21(43), pages 8-31, Junio.
    2. Barros Luís, Jorge & Cassola, Nuno, 2001. "A two-factor model of the German term structure of interest rates," Working Paper Series 0046, European Central Bank.
    3. Nason, James M. & Rogers, John H., 2006. "The present-value model of the current account has been rejected: Round up the usual suspects," Journal of International Economics, Elsevier, vol. 68(1), pages 159-187, January.
    4. Lange, Ron, 1999. "The Expectations Hypothesis for the Longer End of the Term Structure: Some Evidence for Canada," Staff Working Papers 99-20, Bank of Canada.
    5. repec:bdr:ensayo:v::y:2003:i:43:p:8-31 is not listed on IDEAS
    6. Gerald Stuber, 2001. "Implications of Uncertainty about Long-Run Inflation and the Price Level," Staff Working Papers 01-16, Bank of Canada.
    7. Bruno Feunou & Jean-Sébastien Fontaine, 2012. "Forecasting Inflation and the Inflation Risk Premiums Using Nominal Yields," Staff Working Papers 12-37, Bank of Canada.
    8. David Jamieson Bolder, 2001. "Affine Term-Structure Models: Theory and Implementation," Staff Working Papers 01-15, Bank of Canada.

    More about this item


    Financial markets; Inflation and prices; Interest rates; International topics;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets


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