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Federal Reserve Bank of New York
Staff Reports
Decomposing real and nominal yield curves
Michael Abrahams
Tobias Adrian
Richard K. Crump
Emanuel Moench

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.

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Michael Abrahams & Tobias Adrian & Richard K. Crump & Emanuel Moench, Decomposing real and nominal yield curves, Federal Reserve Bank of New York, Staff Reports 570, 2012, revised 01 Feb 2015.
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Note: Previous title: “Pricing TIPS and Treasuries with Linear Regressions”
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Keywords: TIPS; break-evens; expected inflation; inflation risk premium; affine term-structure model; liquidity risk
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