Pricing the term structure of inflation risk premia: Theory and evidence from TIPS |
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Authors: | Ren-Raw Chen Bo Liu Xiaolin Cheng |
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Institution: | 1. Fordham University, 1790 Broadway, Room 1319 New York, NY, 10023, United States;2. Citigroup Global Market, Inc, 390 Greenwich Street, New York, NY, 10013, United States;3. Morgan Stanley, Inc., 750 7th Avenue, New York, NY, 10019, United States |
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Abstract: | In this paper, we study inflation risk and the term structure of inflation risk premia in the United States' nominal interest rates through the Treasury Inflation Protection Securities (TIPS) with a multi-factor, modified quadratic term structure model with correlated real and inflation rates. We derive closed form solutions to the real and nominal term structures of interest rates that drastically facilitate the estimation of model parameters and improve the accuracy of the valuation of nominal rates and TIPS prices. In addition, we contribute to the literature by estimating the term structure of inflation risk premia implied from the TIPS market. The empirical evidence using data from the period of January 1998 through October 2007 indicates that the expected inflation rate, contrary to data derived from the consumer price indices, is very stable and the inflation risk premia exhibit a positive term structure. |
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