An Estimate of the Inflation Risk Premium Using a Three-Factor Affine Term Structure Model

26 Pages Posted: 14 Dec 2006

Date Written: October 2006

Abstract

This paper decomposes nominal Treasury yields into expected real rates, expected inflation rates, real risk premiums, and inflation risk premiums by separately calibrating a three-factor affine term structure model to the nominal Treasury and TIPS yield curves. Although this particular application seems to produce expected real short rates and inflation rates that are somewhat static, there are theoretical advantages to calibrating the model to nominal and real yields separately. Moreover, the estimates correlate positively with back-of-the-envelope measures of the inflation risk premium. With respect to the current environment, monetary policy uncertainty does not seem to have contributed to the apparent increase in the inflation risk premium since the beginning of 2006. Also, in purely nominal terms, the increase in term premiums thus far this year might be just as much a global as a domestic phenomenon, given that nominal term premiums have also increased in Germany and the United Kingdom.

Keywords: Affine term structure model, inflation risk premium

JEL Classification: G0

Suggested Citation

Durham, J. Benson, An Estimate of the Inflation Risk Premium Using a Three-Factor Affine Term Structure Model (October 2006). FEDS Working Paper No. 2006-42. Available at SSRN: https://ssrn.com/abstract=951413 or http://dx.doi.org/10.2139/ssrn.951413

J. Benson Durham (Contact Author)

affiliation not provided to SSRN

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