RDP 2011-01: Estimating Inflation Expectations with a Limited Number of Inflation-indexed Bonds Appendix B: The Mathematics of Our Model

We first give some general results regarding affine term structure models, then relate these results to our specific model and its interpretation.

B.1 Some Results Regarding Affine Term Structure Models

Start with the latent factor process

Given xt we have, for s > t (see, for example, p 342 of Duffie (2001))

where Equation denotes equality in distribution and Equation with

Further, if we define

then since Equation is normally distributed,


where we have used a stochastic version of Fubini's theorem to change the order of integration (see, for example, p 109 of Da Prato and Zabczyk (1992)). Evaluating the inner integral of line (B2), using Itô's Isometry (see, for example, p 82 of Steele (2001)) and making the change of variable s = t + τu we have

where for x a vector we define x2 = x′2 as the vector dot-product x′x. Hence

Now for Equation we have,



where from Kim and Orphanides (2005) for example,

Putting this together we have


Equivalent formula are available in Kim and Orphanides (2005).

B.2 Bond Price Formula

If we model the SDF according to

then the price of a zero-coupon bond at t paying one dollar at t + τ is given by (see, for example, Cochrane (2005))

where Equation is like πs in Equation (B6) above but with

where Equation and Equation (Here Equation is the ‘risk neutral’ version of πs.) Hence we can price bonds via Equation (B3) using K* and μ* in place of K and μ in Equations (B4) and (B5). We can write Equation (B7) as

In terms of the inflation yield from Equation (A5) this can be written as

B.3 Inflation Forecast Formula

Inflation expectations are reported in terms of percentage growth in the consumer price index, not average inflation (the two differ by a Jensen's inequality term). As such, expectations at time t of how the CPI will grow between time s > t and time s + τ in the future correspond to a term of the form

where the last line follows since Equation Here Equation and Equation are equivalent to ατ and βτ from Equations (B4) and (B5) respectively but with the market price or risk λτ set to zero and using −ρ0 and −ρ in place of ρ0 and ρ. So if the CPI is expected to grow by 3 per cent between s and s + τ for example, we would have