Uncovering Inflation Expectations and Risk Premiums from Internationally Integrated Financial Markets

39 Pages Posted: 18 Nov 1999

See all articles by Ben S. C. Fung

Ben S. C. Fung

Bank of Canada

Scott Mitnick

Independent

Eli M. Remolona

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: May 1999

Abstract

Theory and empirical evidence suggest that the term structure of interest rates reflects risk premiums as well as market expectations about future inflation and real interest rates. We propose an approach to extracting such premiums and expectations by exploiting both the comovements among interest rates across the yield curve and between two countries, Canada and the United States. This approach involves estimating a multi-factor affine-yield model jointly for the two countries, in which we identify a common factor as representing real rate expectations and two other factors as representing two separate inflation expectations for the two countries. To estimate the model, we apply a Kalman filter to monthly data on zero-coupon bond yields for 2-year, 5-year and 10-year maturities as well as inflation. Our estimates suggest that Canadian inflation expectations were slow to adjust to a new inflation-targeting regime. We also find inflation-risk premiums that vary between 10 and 90 basis points in the two countries, with U.S. bonds commanding smaller premiums.

JEL Classification: E43, G12, G15

Suggested Citation

Fung, Ben Siu Cheong and Mitnick, Scott and Remolona, Eli M., Uncovering Inflation Expectations and Risk Premiums from Internationally Integrated Financial Markets (May 1999). Available at SSRN: https://ssrn.com/abstract=166652 or http://dx.doi.org/10.2139/ssrn.166652

Ben Siu Cheong Fung (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-7686 (Phone)
613-782-7764 (Fax)

Scott Mitnick

Independent

Eli M. Remolona

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

IFC 2 Bldg, 78/F
Central
Hong Kong
Hong Kong
+852 2982 7150 (Phone)
+852 2982 7123 (Fax)

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