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

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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