Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models

Michael Gallmeyer, Burton Hollifield (), Francisco Palomino and Stanley Zin

No 13245, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E4 G0 G1 (search for similar items in EconPapers)
Date: 2007-07
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Note: AP ME
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Citations: View citations in EconPapers (36)

Published as Michael F. Gallmeyer & Burton Hollifield & Francisco J. Palomino & Stanley E. Zin, 2007. "Arbitrage-free bond pricing with dynamic macroeconomic models," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 305-326.

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