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Arbitrage-free bond pricing with dynamic macroeconomic models
The authors examine the relationship between changes in short-term interest rates induced by monetary policy and the yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. The authors explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. They study the properties of the yield curve when inflation is an exogenous process and compare this with the yield curve when inflation is endogenous and determined through an interest rate (Taylor) rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult because the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation-a necessary condition for an upward-sloping yield curve, as shown in Backus and Zin. Endogenizing inflation provides a substantially better fit of the historical yield curve because the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities, which better fits historical bond data.
AUTHORS: Palomino, Francisco J.; Gallmeyer, Michael F.; Hollifield, Burton; Zin, Stanley E.
Preventing Controversial Catastrophes
In a market-based democracy, we model different constituencies that disagree regarding the likelihood of economic disasters. Costly public policy initiatives to reduce or eliminate disasters are assessed relative to private alternatives presented by financial markets. Demand for such public policies falls as much as 40% with disagreement, and crowding out by private insurance drives most of the reduction. As support for disaster-reducing policy jumps in periods of disasters, costly policies may be adopted only after disasters occur. In some scenarios constituencies may even demand policies oriented to increase disaster risk if these policies introduce speculative opportunities.
AUTHORS: Hollifield, Burton; Baker, Steven D.; Osambela, Emilio