Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models

38 Pages Posted: 9 Jul 2007 Last revised: 11 Sep 2010

See all articles by Michael F. Gallmeyer

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce

Burton Hollifield

Carnegie Mellon University - David A. Tepper School of Business

Francisco Palomino

affiliation not provided to SSRN

Stanley E. Zin

Carnegie Mellon University; National Bureau of Economic Research (NBER)

Date Written: July 2007

Abstract

We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. We study the properties of the yield curve when inflation is an exogenous process and compare this to the yield curve when inflation is endogenous and determined through an interest-rate/Taylor rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult as the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation - a necessary condition for an upward sloping yield curve as shown in Backus and Zin (1994). Endogenizing inflation provides a substantially better fit of the historical yield curve as the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities which better fits historical bond data.

Suggested Citation

Gallmeyer, Michael F. and Hollifield, Burton and Palomino, Francisco and Zin, Stanley E., Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models (July 2007). NBER Working Paper No. w13245. Available at SSRN: https://ssrn.com/abstract=999040

Michael F. Gallmeyer (Contact Author)

University of Virginia (UVA) - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
434-243-4043 (Phone)
434-924-7074 (Fax)

HOME PAGE: http://www.commerce.virginia.edu/faculty_research/facultydirectory/Pages/Gallmeyer.aspx

Burton Hollifield

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
(412) 268-6505 (Phone)
(412) 268-6837 (Fax)

Francisco Palomino

affiliation not provided to SSRN

No Address Available

Stanley E. Zin

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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