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Expectations, risk premia and information spanning in dynamic term structure model estimation

  • Guimarães, Rodrigo

    ()

    (Bank of England)

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    This article examines the nature of the empirical instability in dynamic term structure models. I show that using survey forecasts is an effective solution because it directly addresses the information imbalance at the heart of the instability: it increases the (cross-section) information on actual dynamics, bridging the gap with the large (cross-section) information on the risk-adjusted dynamics. I relate this to other information spanning problems, particularly spanning of macro factors, and discuss the desirability of anchoring models to surveys. I also show that restricting prices of risk is not effective in ensuring stable and sensible implied expectations.

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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2014/wp489.pdf
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    Paper provided by Bank of England in its series Bank of England working papers with number 489.

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    Length: 56 pages
    Date of creation: 28 Mar 2014
    Date of revision:
    Handle: RePEc:boe:boeewp:0489
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    1. Joyce, Michael & Lildholdt, Peter & Sorensen, Steffen, 2009. "Extracting inflation expectations and inflation risk premia from the term structure: a joint model of the UK nominal and real yield curves," Bank of England working papers 360, Bank of England.
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    3. Smith, Tom, 2012. "Option-implied probability distributions for future inflation," Bank of England Quarterly Bulletin, Bank of England, vol. 52(3), pages 224-234.
    4. Carlo Altavilla & Raffaella Giacomini & Giuseppe Ragusa, 2013. "Anchoring the yield curve using survey expectations," CeMMAP working papers CWP52/13, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
    5. Fabio Milani & Ashish Rajbhandari, 2012. "Expectation Formation and Monetary DSGE Models: Beyond the Rational Expectations Paradigm," Working Papers 111212, University of California-Irvine, Department of Economics.
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    7. Michael D. Bauer & Glenn D. Rudebusch & Jing Cynthia Wu, 2012. "Correcting Estimation Bias in Dynamic Term Structure Models," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 30(3), pages 454-467, April.
    8. Athanasios Orphanides & Don H. Kim, 2005. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," Computing in Economics and Finance 2005 474, Society for Computational Economics.
    9. Carvalho, Carlos & Nechio, Fernanda, 2014. "Do people understand monetary policy?," Journal of Monetary Economics, Elsevier, vol. 66(C), pages 108-123.
    10. Jardet, C. & Monfort, A. & Pegoraro, F., 2009. "No-arbitrage Near-Cointegrated VAR(p) Term Structure Models, Term Premia and GDP Growth," Working papers 234, Banque de France.
    11. Stephen Cole & Fabio Milani, 2014. "The Misspecification of Expectations in New Keynesian Models: A DSGE-VAR Approach," Working Papers 131407, University of California-Irvine, Department of Economics.
    12. Albert Lee Chun, 2011. "Expectations, Bond Yields, and Monetary Policy," Review of Financial Studies, Society for Financial Studies, vol. 24(1), pages 208-247.
    13. Ruslan Bikbov & Mikhail Chernov, 2011. "Yield Curve and Volatility: Lessons from Eurodollar Futures and Options," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 9(1), pages 66-105, Winter.
    14. Don H Kim & Athanasios Orphanides, 2007. "The bond market term premium: what is it, and how can we measure it?," BIS Quarterly Review, Bank for International Settlements, June.
    15. Easaw Joshy & Golinelli Roberto, 2010. "Households Forming Inflation Expectations: Active and Passive Absorption Rates," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-32, November.
    16. Heidari, Massoud & Wu, Liuren, 2009. "A Joint Framework for Consistently Pricing Interest Rates and Interest Rate Derivatives," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(03), pages 517-550, June.
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