Inflation, Fisher Equation, and the Term Structure of Inflation Risk Premia: Theory and Evidence from Tips

50 Pages Posted: 29 Sep 2005

See all articles by Ren-Raw Chen

Ren-Raw Chen

Fordham University - Gabelli School of Business

Bo Liu

Rutgers Business School - New Brunswick

Xiaolin Cheng

Rutgers Business School - New Brunswick

Date Written: September 15, 2005

Abstract

In this paper, we study inflation risk and the term structure of inflation risk premia in the U.S. nominal interest rates through the Treasury Inflation Protection Securities (TIPS) and an analytical two-factor Cox-Ingersoll-Ross (CIR) model with correlated real rate and inflation. The analytical formula facilitates the estimation of the model parameters and improves the accuracy of the valuation of nominal rates and TIPS, and especially enables us to estimate the term structure of inflation risk premia.

We use the two-factor model to evaluate the inflation-index bonds and study the relationship between the real rate and the expected inflation rate implied by the nominal Constant Maturity Treasury (CMT) rates for the period of January 1998 through December 2004. We use the Unscented Kalman Filter (UKF) to estimate the model and the inflation risk premium. The empirical evidence indicates that the expected inflation rate, as opposed to those derived from the consumer price indexes, is very stable and the inflation risk premia demonstrate a steep term structure.

Keywords: CIR term structure model of interest rates, TIPS, Unscented Kalman Filter, Inflation Risk Premium

JEL Classification: C51, G12, E43

Suggested Citation

Chen, Ren-Raw and Liu, Bo and Cheng, Xiaolin, Inflation, Fisher Equation, and the Term Structure of Inflation Risk Premia: Theory and Evidence from Tips (September 15, 2005). Available at SSRN: https://ssrn.com/abstract=809346 or http://dx.doi.org/10.2139/ssrn.809346

Ren-Raw Chen (Contact Author)

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
Bronx, NY 10458
United States

Bo Liu

Rutgers Business School - New Brunswick ( email )

New Brunswick, NJ 08901
United States

Xiaolin Cheng

Rutgers Business School - New Brunswick ( email )

94 Rockafeller Road
New Brunswick, NJ 08901
United States

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