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No-arbitrage pricing of GDP-linked bonds

Author

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  • Eguren-Martin, Fernando

    (Bank of England)

  • Meldrum, Andrew

    (Federal Reserve Board)

  • Yan, Wen

    (Barclays Capital)

Abstract

We use a no-arbitrage term structure model of equity yields computed from the prices of dividend swaps to estimate the yields on hypothetical bonds with cash-flows indexed to the level of US GDP. This provides a novel approach for estimating the possible relative cost of conventional and GDP-linked bonds, which is likely to be of interest to sovereigns considering the case for issuing GDP-linked debt. Our model predicts that US GDP-linked bonds would typically have yields lower than those on conventional Treasury bonds with the same maturity in our sample from 2010 to 2017. Positive expected future GDP growth lowers the yield on GDP-linked bonds relative to conventional bonds, which typically more than offsets the estimated GDP risk premium demanded by investors for holding GDP risk. These risk premia decrease with maturity,with unconditional averages falling in absolute value from 7 percentage points at the short-end of the curve to 1 percentage points at the 10-year horizon.

Suggested Citation

  • Eguren-Martin, Fernando & Meldrum, Andrew & Yan, Wen, 2020. "No-arbitrage pricing of GDP-linked bonds," Bank of England working papers 849, Bank of England.
  • Handle: RePEc:boe:boeewp:0849
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    Cited by:

    1. Sarah Mouabbi & Jean-Paul Renne & Jean-Guillaume Sahuc, 2020. "Taming Debt: Can GDP-Linked Bonds Do the Trick?," EconomiX Working Papers 2020-13, University of Paris Nanterre, EconomiX.

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    More about this item

    Keywords

    Affine term structure model (ATSM); bond yield; equity yield; risk premia; dividend swaps; GDP-linked bonds; spanned macroeconomic factors.;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G01 - Financial Economics - - General - - - Financial Crises
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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