A Global Model of International Yield Curves: No-Arbitrage Term Structure Approach
Bank of England
University of Cambridge
James Matthew Smith
Bank of England
April 12, 2011
Bank of England Working Paper No. 419
This paper extends a popular no-arbitrage affine term structure model to model jointly bond markets and exchange rates across the United Kingdom, United States and euro area. Using a monthly data set of forward rates from 1992, we first demonstrate that two global factors account for a significant proportion in the variation of bond yields across countries. We also show that, in order to explain country-specific movements in yield curves, local factors are required. Although we implement a very general factor structure, we find that our global factors are related to global inflation and global economic activity, while local factors are closely linked to monetary policy rates. In this respect our results are similar to previous work. But an important advantage of our joint international model is that we are able to decompose interest rates into risk-free rates and risk premia. Additionally, we are able to study the implications for exchange rates. We show that while differences in risk-free rates matter, to a large extent changes in the exchange rate are determined by time-varying exchange rate risk premia.
Number of Pages in PDF File: 37
Keywords: Term structure models, exchange rates
JEL Classification: C33, E43, F31
Date posted: April 13, 2011 ; Last revised: April 22, 2011
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