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Federal Reserve Bank of Chicago
Working Paper Series
A Portfolio-Balance Approach to the Nominal Term Structure
Thomas B. King
Abstract

Explanations of why changes in the relative quantities of safe debt seem to affect asset prices often appeal informally to a “portfolio balance” mechanism. I show how this type of effect can be incorporated in a general class of structural, arbitrage-free asset-pricing models using a numerical solution method that allows for a wide range of nonlinearities. I consider some applications in which the Treasury market is isolated, investors have mean-variance preferences, and the short-rate process is truncated at zero. Despite its simplicity, a version of this model incorporating inflation can fit longer-term yields well, and it suggests that fluctuations in Treasury supply explain a sizeable fraction of the historical time-series variation in term premia. Nonetheless, under plausible parameterizations central-bank asset purchases have a fairly small impact on the yield curve by removing duration from the market, and these effects are particularly weak when interest rates are close to their zero lower bound.


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Thomas B. King, A Portfolio-Balance Approach to the Nominal Term Structure, Federal Reserve Bank of Chicago, Working Paper Series WP-2013-18, 20 Nov 2013.
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Keywords: Yield curve; LSAP; quantitative easing; preferred habitat forward guidance
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