Extraction of Financial Market Expectations about Inflation and Interest Rates from a Liquid Market

33 Pages Posted: 1 Apr 2009

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2009

Abstract

In this paper we propose an affine model that uses as observed factors the Nelson and Siegel (NS) components summarising the term structure of interest rates. By doing so, we are able to reformulate the Diebold and Li (2006) approach to forecast the yield curve in a way that allows us to incorporate a non-arbitrage opportunities condition and risk aversion into the model. These conditions seem to improve the forecasting ability of the term structure components and provide us with an estimation of the risk premia. Our approach is somewhat equivalent to the recent contribution of Christiensen, Diebold and Rudebusch (2008). However, not only does it seem to be more intuitive and far easier to estimate, it also improves that model in terms of fitting and forecasting properties. Moreover, with this framework it is possible to incorporate directly the inflation rate as an additional factor without reducing the forecasting ability of the model. The augmented model produces an estimation of market expectations about inflation free of liquidity, counterparty and term premia. We provide a comparison of the properties of this indicator with others usually employed to proxy the inflation expectations, such as the break-even rate, inflation swaps and professional surveys.

Keywords: Interest Rate Forecast, Inflation Expectations, Affine Model, Diebold and Li

JEL Classification: G12, E43, E44, C53

Suggested Citation

Gimeno, Ricardo and Marqués, J. Manuel, Extraction of Financial Market Expectations about Inflation and Interest Rates from a Liquid Market (April 1, 2009). Banco de Espana Working Paper No. 0906, Available at SSRN: https://ssrn.com/abstract=1371438 or http://dx.doi.org/10.2139/ssrn.1371438

Ricardo Gimeno (Contact Author)

Banco de España ( email )

Madrid 28014
Spain

J. Manuel Marqués

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

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