A non-knotty inflation risk premium model

Abstract

In this paper I estimate the inflation risk premium (IRP) using a low-dimensional arbitragefree dynamic model through a novel strategy. Instead of modeling the nominal and real yields jointly, I make assumptions about the short-term inflation rate. More specifically, I assume it follows a Gaussian process. This framework has a closed-form expression for IRP. Since inflation yields are not observed, to estimate the model parameters I approximate them by the break-even inflation rate. This approximation works well because the convexity correction is very small. I find the estimated IRP is strongly correlated with those obtained using surveys or more complex models. Therefore, I provide an easier procedure to obtain IRP, avoiding the cumbersome estimation process of high-order models.