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Macro volatility in a model of the UK Gilt edged bond market

  • Peter Spencer

    (University of York)

This paper develops an arbitrage-free macroeconomic model of the yield curve and uses this to explain the behaviour of the UK Treasury bond market. Unlike previous models of this type, which assume a homoscedastic error process I develop a general affine model which allows volatility to be conditioned by the level of inflation (and possibly other macroeconomic variables). In my preferred empirical specification conditional volatility and risk premia are affine in the level of inflation. I test this model against more general specifications in which the risk premia also depend upon interest rate and other macro variables, but find little evidence of these wider effects. The resulting specification provides a parsimonious explanation of the behaviour of the UK yield curve, keying it in to the behaviour of the macroeconomy.

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File URL: http://repec.org/mmf2006/up.27010.1145382051.pdf
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Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 73.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:73
Contact details of provider: Web page: http://www.essex.ac.uk/afm/mmf/index.html

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  1. Tao Wu & Glenn Rudebusch, 2004. "A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy," 2004 Meeting Papers 104, Society for Economic Dynamics.
  2. Pearson, Neil D & Sun, Tong-Sheng, 1994. " Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model," Journal of Finance, American Finance Association, vol. 49(4), pages 1279-1304, September.
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  9. Dewachter, Hans & Lyrio, Marco, 2006. "Macro Factors and the Term Structure of Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(1), pages 119-140, February.
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  11. Friedman, Milton, 1977. "Nobel Lecture: Inflation and Unemployment," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 451-72, June.
  12. Kozicki, Sharon & Tinsley, P. A., 2001. "Shifting endpoints in the term structure of interest rates," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 613-652, June.
  13. Holland, A Steven, 1995. "Inflation and Uncertainty: Tests for Temporal Ordering," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(3), pages 827-37, August.
  14. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
  15. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
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  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. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
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