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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.

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Paper provided by Bank of Canada in its series Working Papers with number 99-6.

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Length: 39 pages
Date of creation: 1999
Date of revision:
Handle: RePEc:bca:bocawp:99-6
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  1. Frederic S. Mishkin, 1989. "The Information in the Longer Maturity Term Structure about Future Inflation," NBER Working Papers 3126, National Bureau of Economic Research, Inc.
  2. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Cowles Foundation Discussion Papers 667, Cowles Foundation for Research in Economics, Yale University.
  3. 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.
  4. Frank F. Gong & Eli M. Remolona, 1996. "Inflation risk in the U.S. yield curve: the usefulness of indexed bonds," Research Paper 9637, Federal Reserve Bank of New York.
  5. Yacine Ait-Sahalia, 1995. "Testing Continuous-Time Models of the Spot Interest Rate," NBER Working Papers 5346, National Bureau of Economic Research, Inc.
  6. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," New York University, Leonard N. Stern School Finance Department Working Paper Seires 96-9, New York University, Leonard N. Stern School of Business-.
  7. Fama, Eugene F., 1984. "The information in the term structure," Journal of Financial Economics, Elsevier, vol. 13(4), pages 509-528, December.
  8. Tzavalis, Elias & Wickens, Michael R, 1997. "Explaining the Failures of the Term Spread Models of the Rational Expectations Hypothesis of the Term Structure," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 364-80, August.
  9. Paul Boothe, 1991. "Interest Parity, Cointegration, and the Term Structure in Canada and the United States," Canadian Journal of Economics, Canadian Economics Association, vol. 24(3), pages 595-603, August.
  10. Brown, Stephen J & Dybvig, Philip H, 1986. " The Empirical Implications of the Cox, Ingersoll, Ross Theory of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 41(3), pages 617-30, July.
  11. Frank F. Gong & Eli M. Remolona, 1997. "A three-factor econometric model of the U.S. term structure," Research Paper 9619, Federal Reserve Bank of New York.
  12. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," NBER Working Papers 5587, National Bureau of Economic Research, Inc.
  13. Jegadeesh, Narasimhan & Pennacchi, George G, 1996. "The Behavior of Interest Rates Implied by the Term Structure of Eurodollar Futures," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 426-46, August.
  14. Martin Evans & Paul Wachtel, 1993. "Inflation regimes and the sources of inflation uncertainty," Proceedings, Federal Reserve Bank of Cleveland, pages 475-520.
  15. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
  16. Longstaff, Francis A & Schwartz, Eduardo S, 1992. " Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model," Journal of Finance, American Finance Association, vol. 47(4), pages 1259-82, September.
  17. Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
  18. Frank F. Gong & Eli M. Remolona, 1996. "Two factors along the yield curve," Research Paper 9613, Federal Reserve Bank of New York.
  19. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc.
  20. Jacobs, Mike & Remolona, Eli & Wickens, Michael R., 1998. "What was the Market's View of UK Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds," CEPR Discussion Papers 2022, C.E.P.R. Discussion Papers.
  21. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
  22. 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.
  23. Jim Day & Ron Lange, 1997. "The Structure of Interest Rates in Canada: Information Content about Medium-Term Inflation," Working Papers 97-10, Bank of Canada.
  24. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
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