We derive the class of affine arbitrage-free dynamic term structure models that approximate the widely used Nelson–Siegel yield curve specification. These arbitrage-free Nelson–Siegel (AFNS) models ...can be expressed as slightly restricted versions of the canonical representation of the three-factor affine arbitrage-free model. Imposing the Nelson–Siegel structure on the canonical model greatly facilitates estimation and can improve predictive performance. In the future, AFNS models appear likely to be a useful workhorse representation for term structure research.
This article presents empirical evidence of a reserve-induced transmission channel of quantitative easing to long-term interest rates. Reserve-induced effects are independent of the assets purchased ...and run through the impact of reserve expansions on bank balance sheets and the resulting bank portfolio rebalancing. For evidence, we analyse the reaction of Swiss long-term government bond yields to announcements by the Swiss National Bank to expand central bank reserves without acquiring any long-lived securities. The data suggest that declines in long-term yields following the announcements mainly reflected reduced term premiums, consistent with reserve-induced portfolio balance effects.
We analyse declines in government bond yields following announcements by the Federal Reserve and the Bank of England of plans to buy longer term debt. Using dynamic term structure models, we ...decompose US and UK yields into expectations about future short-term interest rates and term premiums. We find that declines in US yields mainly reflected lower expectations of future short-term interest rates, while declines in UK yields appeared to reflect reduced term premiums. Thus, the relative importance of the signalling and portfolio balance channels of quantitative easing may depend on market institutional structures and central bank communication policies.
Standard Gaussian affine dynamic term structure models do not rule out negative nominal interest rates -- a conspicuous defect with yields near zero in many countries. Alternative shadow-rate models, ...which respect the nonlinearity at the zero lower bound, have been rarely used because of the extreme computational burden of their estimation. However, by valuing the call option on negative shadow yields, we provide estimates of a three-factor shadow-rate model of Japanese yields. We validate our option-based results by closely matching them using a simulation-based approach. We also show that the shadow short rate is sensitive to model fit and specification.
The downtrend in U.S. interest rates over the past two decades may partly reflect a decline in the longer-run equilibrium real rate of interest. We examine this issue using dynamic term structure ...models that account for time-varying term and liquidity risk premiums and are estimated directly from prices of individual inflation-indexed bonds. Our finance-based approach avoids two potential pitfalls of previous macroeconomic analyses: structural breaks at the zero lower bound and misspecification of output and inflation dynamics. We estimate that the longer-run equilibrium real rate has fallen about 2 percentage points and appears unlikely to rise quickly.
Portfolio diversification is as important to debt management as it is to asset management. In this paper, we focus on diversification of sovereign debt issuance by examining the extension of the ...maximum maturity of issued debt. In particular, we are interested in the potential costs to the U.S. Treasury of introducing 50-year bonds as a financing option. Therefore, we first examine international evidence from four developed foreign government bond markets with such long-term debt. The results show that 50-year bonds in these markets trade at an average yield that is at most 20 basis points above that of 30-year bonds. Results based on extrapolations from a dynamic yield curve model using just U.S. Treasury yields are similar.
•Financing of growing government debt requires a broad range of debt instruments.•Increasing the maximum maturity of government debt offers a way to diversify its risk.•Issuance of a 50-year U.S. Treasury bond would likely be cost effective.
To support the economic recovery, the Federal Reserve amassed a large portfolio of long-term bonds. We assess the Fed׳s associated interest rate risk—including potential losses to its Treasury and ...mortgage-backed securities holdings and declines in the Fed׳s remittances to the Treasury. In assessing this interest rate risk, we use probabilities of alternative interest rate scenarios that are obtained from a dynamic term structure model that respects the zero lower bound on yields. The resulting probability-based stress tests indicate that large portfolio losses or a cessation of remittances to the Treasury are unlikely to occur over the next few years.
•The Federal Reserve׳s expanded balance sheet has greater interest rate risk.•We assess this risk with a probability-based stress test using a yield curve model.•The model generates probabilities of multi-year alternative interest rate scenarios.•We find a low probability that the Fed׳s securities portfolio will be underwater.•We find a low probability that the Fed׳s remittances to the Treasury will stop.
•Central bank asset purchases may affect the targeted assets’ liquidity risk.•TIPS purchases during the Fed’s QE2 program lowered TIPS liquidity premiums.•The importance of this liquidity channel ...depends on financial market conditions.
We argue that central bank large-scale asset purchases—commonly known as quantitative easing (QE)—can reduce priced frictions to trading through a liquidity channel that operates by temporarily increasing the bargaining power of sellers in the market for the targeted securities. For evidence we analyze how the Federal Reserve’s second QE program that included purchases of Treasury inflation-protected securities (TIPS) affected a measure of liquidity premiums in TIPS yields and inflation swap rates. We find that, for the duration of the program, the liquidity premium measure averaged about 10 basis points lower than expected. This suggests that QE can improve market liquidity.
Nearly all studies that analyze the term structure of interest rates take a two-step approach. First, actual bond prices are summarized by interpolated synthetic zero-coupon yields, and second, some ...of these yields are used as the source data for further empirical examination. In contrast, we consider the advantages of a one-step approach that directly analyzes the universe of bond prices. To illustrate the feasibility and desirability of the one-step approach, we compare arbitrage-free dynamic term structure models estimated using both approaches. We also provide a simulation study showing that a one-step approach can extract the information in large panels of bond prices and avoid any arbitrary noise introduced from a first-stage interpolation of yields.
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