This research makes joint use of the prices of nominal and inflation indexed bonds to estimate and study inflation risk premium, inflation expectations, and real and nominal term premia.
First, I use a robust non-parametric procedure on UK data from 1983 to 1999 to extract weekly nominal and inflation indexed zero prices. Then I develop an essentially affine class of models of the real and nominal term structures. Within this class I derive Gaussian and square root examples. I estimate the models with a Kalman filter and find that the data is best fit by a 4 factor Gaussian model.
The estimates support a variable, mostly significant inflation risk premium; on a 10 year bond this is on average 2%, but is initially higher, and eventually indistinguishable from zero; its behavior follows historical events. The variability of the nominal to real yield spread is mostly due to inflation at the short end and to its premium at the long end. A version of the model restricted by the Expectations Hypothesis is strongly rejected by the data.