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Looking Behind the U. K.Term Structure: Were there Peso Problems in Inflation?

  • Martin Evans

    (Georgetown University)

This paper develops and estimates a general equilibrium model for the term structures of nominal and real interest rates that incorporates regime-switching into the dynamics ofthe state variables. The model generates time-varying risk premia via changes in the covariance structure of the state variables and Peso problems through regime- switching. When the model is estimated using real and nominal yields from the U. K., I find that Peso problems emanating from instability in inflation have a significant impact on the nominal term structure. Peso problems affect (i) the sample predictability of excess returns, (ii) nominal term premia,and (iii) the inflation risk premia linking real and nominal yields with expected inflation.

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File URL: http://econwpa.repec.org/eps/fin/papers/9809/9809001.pdf
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Paper provided by EconWPA in its series Finance with number 9809001.

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Date of creation: 01 Sep 1998
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Handle: RePEc:wpa:wuwpfi:9809001
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  1. Kim, Chang-Jin, 1994. "Dynamic linear models with Markov-switching," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 1-22.
  2. Campbell, John Y & Ammer, John, 1993. " What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Journal of Finance, American Finance Association, vol. 48(1), pages 3-37, March.
  3. Martin D. Evans & Karen K. Lewis, 1992. "Do Stationary Risk Premia Explain It All? Evidence from the Term Structure," Working Papers 92-11, New York University, Leonard N. Stern School of Business, Department of Economics.
  4. William Roberds & Charles H. Whiteman, 1996. "Endogenous term premia and anomalies in the term structure of interest rates: explaining the predictability smile," Working Paper 96-11, Federal Reserve Bank of Atlanta.
  5. 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.
  6. Mark Deacon & Andrew Derry, 1994. "Estimating the Term Structure of Interest Rates," Bank of England working papers 24, Bank of England.
  7. Andrew Ang & Geert Bekaert, 1998. "Regime Switches in Interest Rates," NBER Working Papers 6508, National Bureau of Economic Research, Inc.
  8. 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.
  9. 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.
  10. Martin D.D. Evans, 1995. "Peso Problems: Their Theoretical and Empirical Implications," Working Papers 95-05, New York University, Leonard N. Stern School of Business, Department of Economics.
  11. Pearson, N.D. & Sun, T.S., 1991. "An Empirical Examination of the Cox, Ingersoll and Ross Model of the Term Structure of Interest Rates," Papers fb-24, Columbia - Graduate School of Business.
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