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Real Risk, Inflation Risk, and the Term Structure

I develop and estimate a general equilibrium model for the term structures of nominal and real interest rates in the UK that incorporates Markov-switching. The model allows for non-neutralities, nonlinear dynamics, and flexibility in the dynamics of the risk premia - features that are all present in the data. I use the model to assess how accurately the term structure reflects changing expectations of future yields and inflation. This analysis shows that the presence of time-varying risk premia make it very hard to accurately track changes in the expected path of real or nominal yields over horizons of less than five years. By contrast, variations in inflation expected over the next two to three years are very accurately reflected by changes in spread between real and nominal yields, or by changes in nominal yields alone. Over longer horizons, the term structures closely track changing expectations regarding future nominal and real yields but not future inflation.

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Paper provided by Georgetown University, Department of Economics in its series Working Papers with number gueconwpa~02-02-10.

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Date of creation: 10 Feb 2002
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Handle: RePEc:geo:guwopa:gueconwpa~02-02-10
Contact details of provider: Postal: Georgetown University Department of Economics Washington, DC 20057-1036
Phone: 202-687-6074
Fax: 202-687-6102
Web page: http://econ.georgetown.edu/Email:

Order Information: Postal: Roger Lagunoff Professor of Economics Georgetown University Department of Economics Washington, DC 20057-1036
Web: http://econ.georgetown.edu/ Email:


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  1. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1997. ""Peso problem" explanations for term structure anomalies," Working Paper Series, Issues in Financial Regulation WP-97-07, Federal Reserve Bank of Chicago.
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  3. Andrew Ang & Geert Bekaert, 1998. "Regime Switches in Interest Rates," NBER Working Papers 6508, National Bureau of Economic Research, Inc.
  4. Tzavalis, E. & Wickens, M.R., 1995. "Forecasting Inflation from the Term Structure," Discussion Papers 9519, Exeter University, Department of Economics.
  5. Garcia, Rene & Perron, Pierre, 1996. "An Analysis of the Real Interest Rate under Regime Shifts," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 111-25, February.
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  7. Steeley, James M, 1997. "A Two-Factor Model of the U.K. Yield Curve," The Manchester School of Economic & Social Studies, University of Manchester, vol. 65(0), pages 32-58, Supplemen.
  8. 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.
  9. Mark Deacon & Andrew Derry, 1994. "Estimating the Term Structure of Interest Rates," Bank of England working papers 24, Bank of England.
  10. Roberds, William & Whiteman, Charles H., 1999. "Endogenous term premia and anomalies in the term structure of interest rates: Explaining the predictability smile," Journal of Monetary Economics, Elsevier, vol. 44(3), pages 555-580, December.
  11. Sola, Martin & Driffill, John, 1994. "Testing the term structure of interest rates using a stationary vector autoregression with regime switching," Journal of Economic Dynamics and Control, Elsevier, vol. 18(3-4), pages 601-628.
  12. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1996. "On Biases in Tests of the Expecations Hypothesis of the Term Structure Of Interest Rates," NBER Technical Working Papers 0191, National Bureau of Economic Research, Inc.
  13. John Y. Campbell & Luis M. Viceira, 1998. "Who Should Buy Long-Term Bonds?," NBER Working Papers 6801, National Bureau of Economic Research, Inc.
  14. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
  15. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De.
  16. Conley, Timothy G, et al, 1997. "Short-Term Interest Rates as Subordinated Diffusions," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 525-77.
  17. 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.
  18. Fama, Eugene F., 1990. "Term-structure forecasts of interest rates, inflation and real returns," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 59-76, January.
  19. David Barr & Bahram Pesaran, 1995. "An assessment of the relative importance of real interest rates, inflation and term premia in determining the prices of real and nominal UK bonds," Bank of England working papers 32, Bank of England.
  20. Evans, Martin D D, 1998. "Dividend Variability and Stock Market Swings," Review of Economic Studies, Wiley Blackwell, vol. 65(4), pages 711-40, October.
  21. Evans, Martin D. D. & Lewis, Karen K., 1994. "Do stationary risk premia explain it all?: Evidence from the term structure," Journal of Monetary Economics, Elsevier, vol. 33(2), pages 285-318, April.
  22. Arak, Marcelle & Kreicher, Lawrence, 1985. "The Real Rate of Interest: Inferences from the New U.K. Indexed Gilts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 399-408, June.
  23. Ravi Bansal & Hao Zhou, 2001. "Term structure of interest rates with regime shifts," Finance and Economics Discussion Series 2001-46, Board of Governors of the Federal Reserve System (U.S.).
  24. Stanton, Richard, 1997. " A Nonparametric Model of Term Structure Dynamics and the Market Price of Interest Rate Risk," Journal of Finance, American Finance Association, vol. 52(5), pages 1973-2002, December.
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