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Discussion Paper
Tips from TIPS: Update and Discussions
In this Note, we update and extend the estimation to a longer period from 1983 to the present.
Journal Article
Challenges in macro-finance modeling
This article discusses various challenges in the specification and implementation of "macro-finance" models in which macroeconomic variables and term structure variables are modeled together in a no-arbitrage framework. The author classifies macro-finance models into pure latent-factor models ("internal basis models") and models that have observed macroeconomic variables as state variables ("external basis models") and examines the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macroeconomic variables ...
Working Paper
Are Shadow Rate Models of the Treasury Yield Curve Structurally Stable?
We examine the structural stability of Gaussian shadow rate term structure models of Treasury yields over a period that includes the time during which the U.S. policy rate was at its effective lower bound. After a conceptual discussion of several potential sources of a structural break in the context of the shadow rate model, we document various pieces of evidence for structural instability based on predictive tests and Lagrange multiplier tests, as well as with separate estimations of the pre-ELB and post-ELB subsamples. In order to overcome the difficulties associated with the latent-factor ...
Working Paper
Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices
Treasury Inflation-Protected Securities (TIPS) are frequently thought of as risk-free real bonds. Using no-arbitrage term structure models, we show that TIPS yields exceeded risk-free real yields by as much as 100 basis points when TIPS were first issued and up to 300 basis points during the recent financial crisis. This spread reflects predominantly the poorer liquidity of TIPS relative to nominal Treasury securities. Other factors, including the indexation lag and the embedded deflation protection in TIPS, play a much smaller role. Ignoring this spread also significantly distorts the ...
Working Paper
Zero bound, option-implied PDFs, and term structure models
This paper points out that several known ways of modeling non-negative nominal interest rates lead to different implications for the risk-neutral distribution of the short rate that can be checked with options data. In particular, Black's boundary models ("interest rates as options") imply a probability density function (pdf) that contains a Dirac delta function and a cumulative distribution function (cdf) that is nonzero at the zero boundary, while models like the CIR and positive-definite quadratic-Gaussian (QG) models have a zero cdf at the boundary. Eurodollar futures options data are ...
Working Paper
Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices
TIPS breakeven inflation rate, defined as the difference between nominal and TIPS yields of comparable maturities, is potentially useful as a real-time measure of market inflation expectations. In this paper, we provide evidence that a fairly large TIPS liquidity premium existed until recently, using a multifactor no-arbitrage term structure model estimated with nominal and TIPS yields, inflation and survey forecasts of interest rates. Ignoring the TIPS liquidity premiums leads to counterintuitive implications for inflation expectations and inflation risk premium, and produces large pricing ...
Working Paper
An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates
This paper reviews a simple three-factor arbitrage-free term structure model estimated by Federal Reserve Board staff and reports results obtained from fitting this model to U.S. Treasury yields since 1990. The model ascribes a large portion of the decline in long-term yields and distant-horizon forward rates since the middle of 2004 to a fall in term premiums. A variant of the model that incorporates inflation data indicates that about two-thirds of the decline in nominal term premiums owes to a fall in real term premiums, but estimated compensation for inflation risk has diminished as well.
Working Paper
Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices
We examine the informational content of TIPS yields from the viewpoint of a general 3-factor no-arbitrage term structure model of inflation and interest rates. Our empirical results indicate that TIPS yields contained a "liquidity premium" that was until recently quite large (~ 1%). Key features of this premium are difficult to account for in a rational pricing framework, suggesting that TIPS may not have been priced efficiently in its early years. Besides the liquidity premium, a time-varying inflation risk premium complicates the interpretation of the TIPS breakeven inflation rate (the ...
Working Paper
Challenges in macro-finance modeling
This paper discusses various challenges in the specification and implementation of ?macro-finance? models in which macroeconomic variables and term structure variables are modeled together in a no-arbitrage framework. I classify macro-finance models into pure latent-factor models (?internal basis models?) and models which have observed macroeconomic variables as state variables (?external basis models?), and examine the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macro variables and their potentially adverse ...
Working Paper
Jumps in Bond Yields at Known Times
We construct a no-arbitrage term structure model with jumps in the entire state vector at deterministic times but of random magnitudes. Jump risk premia are allowed for. We show that the model implies a closed-form representation of yields as a time-inhomogeneous affine function of the state vector, and derive other theoretical implications. We apply the model to the term structure of US Treasury rates, estimated at the daily frequency, allowing for jumps on days of employment report announcements. Our model can match the empirical fact that the term structure of interest rate volatility has ...