Comment on "Term Premia and Inflation Uncertainty: Empirical Evidence from an International Panel Dataset" with Michael D. Bauer and Glenn D. Rudebusch, forthcoming in American Economic Review.Abstract
Term premia implied by maximum likelihood estimates of affine term structure models are misleading because of small-sample bias. We show that accounting for this bias alters the conclusions about the trend, cycle, and macroeconomic determinants of the term premia estimated in Wright (2011). His term premium estimates are essentially acyclical, and often just parallel the secular trend in long-term interest rates. In contrast, bias-corrected term premia show pronounced counter-cyclical behavior, consistent with theoretical and empirical arguments about movements in risk premia.
"Testable Implications of Affine Term Structure Models" with James D. Hamilton, forthcoming in Journal of Econometrics.Abstract
Affine term structure models have been used to address a wide range of questions in macroeconomics and finance. This paper investigates a number of their testable implications which have not previously been explored. We show that the assumption that certain specified yields are priced without error is testable, and find that the implied measurement or specification error exhibits serial correlation in all of the possible formulations investigated here. We further find that the predictions of these models for the average levels of different interest rates are inconsistent with the observed data, and propose a more general specification that is not rejected by the data.
"Risk Premia in Crude Oil Futures Prices" with James D. Hamilton, forthcoming in Journal of International Money and Finance.Abstract
If commercial producers or financial investors use futures contracts to hedge against commodity price risk, the arbitrageurs who take the other side of the contracts may receive compensation for their assumption of nondiversifiable risk in the form of positive expected returns from their positions. We show that this interaction can produce an affine factor structure to commodity futures prices, and develop new algorithms for estimation of such models using unbalanced data sets in which the duration of observed contracts changes with each observation. We document significant changes in oil futures risk premia since 2005, with the compensation to the long position smaller on average but more volatile in more recent data. This observation is consistent with the claim that index-fund investing has become more important relative to commerical hedging in determining the structure of crude oil futures risk premia over time.
"Correcting Estimation Bias in Dynamic Term Structure Models" with Michael D. Bauer and Glenn D. Rudebusch, Journal of Business & Economic Statistics, 2012, Vol 30 (3), pp 454-467Abstract
The affine dynamic term structure model (DTSM) is the canonical empirical finance representation of the yield curve. However, the possibility that DTSM estimates may be distorted by small-sample bias has been largely ignored. We show that conventional estimates of DTSM coefficients are indeed severely biased, and this bias results in misleading estimates of expected future short-term interest rates and of long-maturity term premia. We provide a variety of bias-corrected estimates of affine DTSMs, both for maximallyflexible and over-identified specifications. Our estimates imply short rate expectations and term premia that are more plausible from a macro-finance perspective.
The affine dynamic term structure model (DTSM) is the canonical empirical finance representation of the yield curve. However, the possibility that DTSM estimates may be distorted by small-sample bias has been largely ignored. We show that conventional estimates of DTSM coefficients are indeed severely biased, and this bias results in misleading estimates of expected future short-term interest rates and of long-maturity term premia. We provide a variety of bias-corrected estimates of affine DTSMs, both for maximally-flexible and over-identified specifications. Our estimates imply short rate expectations and term premia that are more plausible from a macro-finance perspective.
"Identification and Estimation of Gaussian Affine Term Structure Models" with James D. Hamilton, Journal of Econometrics, 2012, Vol 168 (2), pp. 315-331.Abstract
This paper develops new results for identification and estimation of Gaussian affine term structure models. We establish that three popular canonical representations are unidentified, and demonstrate how unidentified regions can complicate numerical optimization. A separate contribution of the paper is the proposal of minimum-chi-square estimation as an alternative to MLE. We show that, although it is asymptotically equivalent to MLE, it can be much easier to compute. In some cases, MCSE allows researchers to recognize with certainty whether a given estimate represents a global maximum of the likelihood function and makes feasible the computation of small-sample standard errors.
"The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment" with James D. Hamilton. Journal of Money, Credit, and Banking, 2012, Vol 44 (s1), pp 3-46.Abstract
This paper reviews alternative options for monetary policy when the short-term interest rate is at the zero lower bound and develops new empirical estimates of the effects of the maturity structure of publicly held debt on the term structure of interest rates. We use a model of risk-averse arbitrageurs to develop measures of how the maturity structure of debt held by the public might affect the pricing of level, slope and curvature term-structure risk. We find these Treasury factors historically were quite helpful for predicting both yields and excess returns over 1990-2007. The historical correlations are consistent with the claim that if in December of 2006, the Fed were to have sold off all its Treasury holdings of less than one-year maturity (about $400 billion) and use the proceeds to retire Treasury debt from the long end, this might have resulted in a 14-basis-point drop in the 10-year rate and an 11-basis-point increase in the 6-month rate. We also develop a description of how the dynamic behavior of the term structure of interest rates changed after hitting the zero lower bound in 2009. Our estimates imply that at the zero lower bound, such a maturity swap would have the same effects as buying $400 billion in long-term maturities outright with newly created reserves, and could reduce the 10-year rate by 13 basis points without raising short-term yields.
"Estimation of Non-Gaussian Affine Term Structure Models" with Drew D. Creal, March 2013.Abstract
We propose a new estimation approach for non-Gaussian affine term structure models. First, we generalize discrete-time models to allow for any admissible affine rotation of the state vector and we derive a closed-form transition density for all models within this family. Our second contribution is a new approach to estimate the models using an exact concentrated log-likelihood function that reduces the dimension of the parameter space and eliminates parameters that often cause problems for conventional estimation procedures. Third, we derive the analytical gradients for the log-likelihood. Our approach outperforms conventional methods by consistently finding the maxima. It is also more than 60 times faster, dropping estimation time from several hours to a couple minutes. We illustrate how our method can include observable macroeconomic variables, hidden factors, and allow for restrictions on the key parameters of interest. Using our approach, we investigate the nature and economic implications of the likelihood surface.
"Inflation Announcements and Social Dynamics" with Kinda Hachem, November 2012.Abstract
This paper investigates the effectiveness of central bank communication when firms have heterogeneous inflation expectations that are updated through social dynamics. The bank's credibility evolves with these dynamics and determines how well its announcements anchor expectations. We show that trying to eliminate high inflation by abruptly introducing a low inflation target can lead to short-term overshooting whereas gradually introducing the target directs the economy to the long-term goal more quickly and smoothly. In contrast, avoiding a protracted deflation requires aggressive announcements that could more easily be accommodated under price-level targeting. For an inflation targeting central bank, we find that varying two dimensions of quantitative easing - number of rounds and intensity of announcements - provides an effective way to stem deflationary expectations without altering inflation targets.
"Effects of Index-Fund Investing on Commodity Futures Prices" with James D. Hamilton, May 2013.Abstract
The last decade brought substantial increased participation in commodity markets by index funds that maintain long positions in the near futures contracts. Policy makers and academic studies have reached sharply different conclusions about the effects of these funds on commodity futures prices. This paper proposes a unifying framework for examining this question, noting that according to a simple model of futures arbitrage, if index-fund buying influences prices by changing the risk premium, then the notional positions of the index investors should help predict excess returns in these contracts. We find no evidence that the positions of traders in agricultural contracts identified by the CFTC as following an index strategy can help predict returns on the near futures contracts. We review evidence that these positions might help predict changes in oil futures prices, and find that while there is some support for this in the earlier data, this appears to be driven by some of the dramatic features of the 2007-2009 recession, with the relation breaking down out of sample.