Risk Premiums in Dynamic Term Structure Models with Unspanned Macro Risks
TL;DR: This article quantified how variation in real economic activity and ination in the U.S. Treasury market inuenced the market prices of level, slope, and curvature risks.
Abstract: This paper quanties how variation in real economic activity and ination in the U.S. inuenced the market prices of level, slope, and curvature risks in U.S. Treasury markets. To accomplish this we develop a novel arbitrage-free DTSM in which macroeconomic risks{ in particular, real output and ination risks{ impact bond investment decisions separately from information about the shape of the yield curve. Estimates of our preferred macro-DTSM over the twenty-three year period from 1985 through 2007 reveal that unspanned macro risks explained a substantial proportion of the variation in forward terms premiums. Unspanned macro risks accounted for nearly 90% of the conditional variation in short-dated forward term premiums, with unspanned real economic growth being the key driving factor. Over horizons beyond three years, these eects were entirely attributable to unspanned ination. Using our model, we also reassess some of Chairman Bernanke’s remarks on the interplay between term premiums, the shape of the yield curve, and macroeconomic activity.
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TL;DR: In this article, a model-free analysis and dynamic term structure models were used to decompose declines in yields following Fed announcements into changes in risk premia and expected short rates.
Abstract: Previous research has emphasized the portfolio balance effects of Federal Reserve bond purchases, in which a reduced bond supply lowers term premia. In contrast, we find that such purchases have important signaling effects that lower expected future short-term interest rates. Our evidence comes from a model-free analysis and from dynamic term structure models that decompose declines in yields following Fed announcements into changes in risk premia and expected short rates. To overcome problems in measuring term premia, we consider bias-corrected model estimation and restricted risk price estimation. In comparison with other studies, our estimates of signaling effects are larger in magnitude and statistical significance.
368 citations
TL;DR: The authors developed a canonical Gaussian dynamic term structure model (GDTSM) in which the pricing factors are observable portfolios of yields, and provided empirical estimates and out-of-sample forecasts for several GDTSMs using data on U.S. Treasury bond yields.
Abstract: In any canonical Gaussian dynamic term structure model (GDTSM), the conditional forecasts of the pricing factors are invariant to the imposition of no-arbitrage restrictions. This invariance is maintained even in the presence of a variety of restrictions on the factor structure of bond yields. To establish these results, we develop a novel canonical GDTSM in which the pricing factors are observable portfolios of yields. For our normalization, standard maximum likelihood algorithms converge to the global optimum almost instantaneously. We present empirical estimates and out-of-sample forecasts for several GDTSMs using data on U.S. Treasury bond yields. (JEL E43, G12, C13) Dynamic models of the term structure often posit a linear factor structure for a collection of yields, with these yields related to underlying factors P through a no-arbitrage relationship. Does the imposition of no-arbitrage in a Gaussian dynamic term structure model (GDTSM) improve the out-of-sample forecasts of yields relative to those from the unconstrained factor model, or sharpen model-implied estimates of expected excess returns? In practice, the answers to these questions are obscured by the imposition of over-identifying restrictions on the risk-neutral (Q) or historical (P) distributions of the risk factors, or on their market prices of risk, in addition to the cross-maturity restrictions implied by no-arbitrage. 1
326 citations
TL;DR: In this paper, a three-step linear regression approach is used to price the time series and cross section of the term structure of interest rates using a large number of pricing factors.
292 citations
TL;DR: The authors provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance, and shows that many features of the configuration of interest rate are puzzling from the perspective of the expectations hypothesis.
Abstract: This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from longer-term interest rates, and take actions to influence those rates. The simplest model of the term structure is the expectations hypothesis, which posits that long-term interest rates are expectations of future aver- age short-term rates. In this paper, we show that many features of the configuration of interest rates are puzzling from the perspective of the expectations hypothesis. We review models that explain these anomalies using time-varying risk premia. Although the quest for the fundamental macroeconomic explanations of these risk premia is ongoing, inflation uncertainty seems to play a large role. Finally, while modern finance theory prices bonds and other assets in a single unified framework, we also consider an earlier approach based on segmented markets. Market segmentation seems important to understand the term structure of interest rates during the recent financial crisis. ( JEL E31, E43, E52, E58)
290 citations
TL;DR: In this article, the authors show that conventional estimates of DTSM coefficients are indeed severely biased, and this bias results in misleading estimates of expected future short-term interest rates and of long-maturity term premia.
Abstract: The affine dynamic term structure model (DTSM) is the canonical empirical finance representation of the yield curve. However, the possibility that DTSM estimates may be distorted by small-sample bias has been largely ignored. We show that conventional estimates of DTSM coefficients are indeed severely biased, and this bias results in misleading estimates of expected future short-term interest rates and of long-maturity term premia. We provide a variety of bias-corrected estimates of affine DTSMs, for both maximally flexible and overidentified specifications. Our estimates imply interest rate expectations and term premia that are more plausible from a macrofinance perspective. This article has supplementary material online.
222 citations
References
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TL;DR: In this paper, the problem of selecting one of a number of models of different dimensions is treated by finding its Bayes solution, and evaluating the leading terms of its asymptotic expansion.
Abstract: The problem of selecting one of a number of models of different dimensions is treated by finding its Bayes solution, and evaluating the leading terms of its asymptotic expansion. These terms are a valid large-sample criterion beyond the Bayesian context, since they do not depend on the a priori distribution.
38,681 citations
01 Jan 2005
TL;DR: In this paper, the problem of selecting one of a number of models of different dimensions is treated by finding its Bayes solution, and evaluating the leading terms of its asymptotic expansion.
Abstract: The problem of selecting one of a number of models of different dimensions is treated by finding its Bayes solution, and evaluating the leading terms of its asymptotic expansion. These terms are a valid large-sample criterion beyond the Bayesian context, since they do not depend on the a priori distribution.
36,760 citations
04 Oct 2007
TL;DR: This reference work and graduate level textbook considers a wide range of models and methods for analyzing and forecasting multiple time series, which include vector autoregressive, cointegrated, vector Autoregressive moving average, multivariate ARCH and periodic processes as well as dynamic simultaneous equations and state space models.
Abstract: This reference work and graduate level textbook considers a wide range of models and methods for analyzing and forecasting multiple time series. The models covered include vector autoregressive, cointegrated, vector autoregressive moving average, multivariate ARCH and periodic processes as well as dynamic simultaneous equations and state space models. Least squares, maximum likelihood, and Bayesian methods are considered for estimating these models. Different procedures for model selection and model specification are treated and a wide range of tests and criteria for model checking are introduced. Causality analysis, impulse response analysis and innovation accounting are presented as tools for structural analysis. The book is accessible to graduate students in business and economics. In addition, multiple time series courses in other fields such as statistics and engineering may be based on it. Applied researchers involved in analyzing multiple time series may benefit from the book as it provides the background and tools for their tasks. It bridges the gap to the difficult technical literature on the topic.
5,244 citations
Book•
01 Jan 2003TL;DR: Woodford as discussed by the authors proposes a rule-based approach to monetary policy suitable for a world of instant communications and ever more efficient financial markets, arguing that effective monetary policy requires that central banks construct a conscious and articulate account of what they are doing.
Abstract: With the collapse of the Bretton Woods system, any pretense of a connection of the world's currencies to any real commodity has been abandoned. Yet since the 1980s, most central banks have abandoned money-growth targets as practical guidelines for monetary policy as well. How then can pure "fiat" currencies be managed so as to create confidence in the stability of national units of account? Interest and Prices seeks to provide theoretical foundations for a rule-based approach to monetary policy suitable for a world of instant communications and ever more efficient financial markets. In such a world, effective monetary policy requires that central banks construct a conscious and articulate account of what they are doing. Michael Woodford reexamines the foundations of monetary economics, and shows how interest-rate policy can be used to achieve an inflation target in the absence of either commodity backing or control of a monetary aggregate. The book further shows how the tools of modern macroeconomic theory can be used to design an optimal inflation-targeting regime--one that balances stabilization goals with the pursuit of price stability in a way that is grounded in an explicit welfare analysis, and that takes account of the "New Classical" critique of traditional policy evaluation exercises. It thus argues that rule-based policymaking need not mean adherence to a rigid framework unrelated to stabilization objectives for the sake of credibility, while at the same time showing the advantages of rule-based over purely discretionary policymaking.
4,938 citations
Book•
01 Jan 2003TL;DR: Woodford as mentioned in this paper proposes a rule-based approach to monetary policy suitable for a world of instant communications and ever more efficient financial markets, arguing that effective monetary policy requires that central banks construct a conscious and articulate account of what they are doing.
Abstract: With the collapse of the Bretton Woods system, any pretense of a connection of the world's currencies to any real commodity has been abandoned. Yet since the 1980s, most central banks have abandoned money-growth targets as practical guidelines for monetary policy as well. How then can pure "fiat" currencies be managed so as to create confidence in the stability of national units of account? Interest and Prices seeks to provide theoretical foundations for a rule-based approach to monetary policy suitable for a world of instant communications and ever more efficient financial markets. In such a world, effective monetary policy requires that central banks construct a conscious and articulate account of what they are doing. Michael Woodford reexamines the foundations of monetary economics, and shows how interest-rate policy can be used to achieve an inflation target in the absence of either commodity backing or control of a monetary aggregate. The book further shows how the tools of modern macroeconomic theory can be used to design an optimal inflation-targeting regime--one that balances stabilization goals with the pursuit of price stability in a way that is grounded in an explicit welfare analysis, and that takes account of the "New Classical" critique of traditional policy evaluation exercises. It thus argues that rule-based policymaking need not mean adherence to a rigid framework unrelated to stabilization objectives for the sake of credibility, while at the same time showing the advantages of rule-based over purely discretionary policymaking.
4,823 citations