Report

Decomposing real and nominal yield curves


Abstract: We present an affine term structure model for the joint pricing of Treasury Inflation-Protected Securities (TIPS) and Treasury yield curves that adjusts for TIPS? relative illiquidity. Our estimation using linear regressions is computationally very fast and can accommodate unspanned factors. The baseline specification with six principal components extracted from Treasury and TIPS yields, in combination with a liquidity factor, generates negligibly small pricing errors for both real and nominal yields. Model-implied expected inflation provides a better prediction of actual inflation than breakeven inflation. The value of the deflation floor calculated from the model is generally small in magnitude, but spiked during the recent crisis.

Keywords: TIPS; break-evens; expected inflation; inflation risk premium; affine term-structure model; liquidity risk;

JEL Classification: E43; E44; G12;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2015-02-01

Order Number: 570

Note: Previous title: “Pricing TIPS and Treasuries with Linear Regressions”