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

58 Pages Posted: 14 Mar 2011  

Joseph G. Haubrich

Federal Reserve Bank of Cleveland

George Pennacchi

University of Illinois

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

Date Written: March 12, 2011

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.

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

JEL Classification: E43, G12, E52

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: https://ssrn.com/abstract=1784067 or http://dx.doi.org/10.2139/ssrn.1784067

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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