Forthcoming in Journal of Monetary Economics | With Lopez and Rudebusch
To support the economy, 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 securities holdings and declines in remittances to the Treasury. Unlike past examinations of this interest rate risk, we attach probabilities to alternative interest rate scenarios. These probabilities are obtained from a dynamic term structure model that respects the zero lower bound on yields. The resulting probability-based stress test finds that the Fed’s losses are unlikely to be large and remittances are unlikely to exhibit more than a brief cessation.
Forthcoming in Review of Finance | With Lopez and Rudebusch
We use an arbitrage-free term structure model with spanned stochastic volatility to determine the value of the deflation protection option embedded in Treasury inflation protected securities (TIPS). The model accurately prices the deflation protection option prior to the financial crisis when its value was near zero; at the peak of the crisis in late 2008 when deflationary concerns spiked sharply; and in the post-crisis period. During 2009, the average value of this option at the five-year maturity was 41 basis points on a par-yield basis. The option value is shown to be closely linked to overall market uncertainty as measured by the VIX, especially during and after the 2008 financial crisis.
Journal of Financial Econometrics 13 (2), Spring 2015, 226-259 | With Rudebusch
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 the first estimates of a three-factor shadow-rate model. 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.
Journal of Business and Economic Statistics 32(1), January 2014, 136-151 | With Lopez and Rudebusch
In response to the global financial crisis that started in August 2007, central banks provided extraordinary amounts of liquidity to the financial system. To investigate the effect of central bank liquidity facilities on term interbank lending rates, we estimate a six-factor
arbitrage-free model of U.S. Treasury yields, financial corporate bond yields, and term interbank rates. This model can account for fluctuations in the term structure of credit risk and liquidity risk. A significant shift in model estimates after the announcement of
the liquidity facilities suggests that these central bank actions did help lower the liquidity premium in term interbank rates.
International Journal of Central Banking 8(4), December 2012, 21-60 | With Lopez and Rudebusch
We construct probability forecasts for episodes of price deflation (i.e., a falling price level) using yields on nominal and real U.S. Treasury bonds. The deflation probability forecasts identify two “deflation scares” during the past decade: a mild one following the 2001 recession and a more serious one starting in late 2008 with the deepening of the financial crisis. The estimated deflation probabilities are generally consistent with those from macroeconomic models and surveys of professional forecasters, but they also provide high-frequency insight into the views of financial market participants. The probabilities can also be used to price the deflation protection option embedded in real Treasury bonds.
Economic Journal 122(564), November 2012, F385-F414 | With Rudebusch
We analyze 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.
The Affine Arbitrage-Free Class of Nelson-Siegel Term Structure Models
Journal of Econometrics 164, September 2011, 4-20 | With Diebold and Rudebusch
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.
Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields
Journal of Money, Credit, and Banking 42, September 2010, 143-178 | With Lopez and Rudebusch
Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average.
Econometrics Journal 12(3), November 2009, 33-64 | With Diebold and Rudebusch
The Svensson generalization of the popular Nelson-Siegel term structure model is widely used by practitioners and central banks. Unfortunately, like the original Nelson-Siegel specification, this generalization, in its dynamic form, does not enforce arbitrage-free consistency over time. Indeed, we show that the factor loadings of the Svensson generalization cannot be obtained in a standard finance arbitrage-free affine term structure representation. Therefore, we introduce a closely related generalized Nelson-Siegel model on which the no-arbitrage condition can be imposed. We estimate this new arbitrage-free generalized Nelson-Siegel model and demonstrate its tractability and good in-sample fit.
Confidence Sets for Continuous-Time Rating Transition Probabilities
Journal of Banking and Finance 28, August 2004, 2575-2602 | With Lando and Hansen
This paper addresses the estimation of default probabilities and associated confidence sets with special focus on rare events. Research on rating transition data has documented a tendency for recently downgraded issuers to be at an increased risk of experiencing further downgrades
compared to issuers that have held the same rating for a longer period of time. To capture this non-Markov effect we introduce a continuous-time hidden Markov chain model in which downgrades firms enter into a hidden, “excited” state. Using data from Moody’s we estimate the parameters of the model, and conclude that both default probabilities and confidence sets are strongly influenced by the introduction of hidden excited states.