Abstract

http://ssrn.com/abstract=1784067
 
 

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Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps


Joseph G. Haubrich


Federal Reserve Bank of Cleveland

George Pennacchi


University of Illinois

Peter H. Ritchken


Case Western Reserve University - Department of Banking & Finance

March 12, 2011

FRB of Cleveland Working Paper No. 1107

Abstract:     
This paper develops a model of the term structures of nominal and real interest rates driven by state variables representing the short-term real interest rate, expected inflation, inflation’s central tendency, and four volatility factors that follow GARCH processes. We derive analytical solutions for nominal bond yields, yields on inflation-indexed bonds that have an indexation lag, and the term structure of expected inflation. Unlike prior studies, the model’s parameters are estimated using data on inflation swap rates, as well as nominal yields and survey forecasts of inflation. The volatility state variables fully determine bonds’ time-varying risk premia and allow for stochastic volatility and correlation between bond yields, yet they have small effects on the cross section of nominal yields. Allowing for time-varying volatility is particularly important for real interest rate and expected inflation processes, but long-horizon real and inflation risk premia are relatively stable. Comparing our model prices of inflation-indexed bonds to those of Treasury Inflation Protected Securities (TIPS) suggests that TIPS were significantly underpriced prior to 2004 and again during the 2008-2009 financial crisis.

Number of Pages in PDF File: 58

Keywords: Term structure of interest rates, infl ation expectations, asset pricing

JEL Classification: E43, G12, E52

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Date posted: March 14, 2011  

Suggested Citation

Haubrich, Joseph G. and Pennacchi, George and Ritchken, Peter H., Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps (March 12, 2011). FRB of Cleveland Working Paper No. 1107. Available at SSRN: http://ssrn.com/abstract=1784067 or http://dx.doi.org/10.2139/ssrn.1784067

Contact Information

Joseph G. Haubrich (Contact Author)
Federal Reserve Bank of Cleveland ( email )
East 6th & Superior
Cleveland, OH 44101-1387
United States
216-579-2802 (Phone)
216-579-3050 (Fax)
George G. Pennacchi
University of Illinois ( email )
4041 BIF, Box 25
515 East Gregory Drive
Champaign, IL 61820
United States
217-244-0952 (Phone)
HOME PAGE: http://www.business.illinois.edu/gpennacc/
Peter H. Ritchken
Case Western Reserve University - Department of Banking & Finance ( email )
10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)
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