TAILIEUCHUNG - Estimating Inflation Expectations with a Limited Number of Inflation-Indexed Bonds ∗

In the mid-1990’s catastrophe bonds (CAT bonds), also named as Act of God or Insurance-linked bond, were developed to ease the transfer of catastrophe based insurance risk from insurers, reinsurers and corporations (sponsors) to capital market investors. CAT bonds are bonds whose coupons and principal payments depend on the performance of a pool or index of natural catastrophe risks, or on the presence of specified trigger conditions. They protect sponsor companies from financial losses caused by large natural disasters by offering an alternative or complement to traditional reinsurance. The transaction involves four parties: the sponsor or ceding company (government agencies, insurers, reinsurers), the special purpose vehicle SPV (or issuer),. | Estimating Inflation Expectations with a Limited Number of Inflation-Indexed Bonds Richard Finlay and Sebastian Wende Reserve Bank of Australia We develop a novel technique to estimate inflation expectations and inflation risk premia when only a limited number of inflation-indexed bonds are available. The method involves pricing coupon-bearing inflation-indexed bonds directly in terms of an affine term structure model and avoids the usual requirement of estimating zero-coupon real yield curves. We estimate the model using a non-linear Kalman filter and apply it to Australia. The results suggest that long-term inflation expectations in Australia are well anchored within the Reserve Bank of Australia s inflation target range of 2 to 3 percent and that inflation expectations are less volatile than inflation risk premia. JEL Codes E31 E43 G12. 1. Introduction Reliable and accurate estimates of inflation expectations are important to central banks given the role of these expectations in influencing inflation and economic activity. Inflation expectations may also indicate over what horizon individuals believe that a central bank will achieve its inflation target if at all. A common measure of inflation expectations based on financial market data is the break-even inflation yield referred to simply as the inflation yield. The inflation yield is given by the difference in The authors thank Rudolph van der Merwe for help with the central difference Kalman filter as well as Adam Cagliarini Jonathan Kearns Christopher Kent Frank Smets Ian Wilson and an anonymous referee for useful comments and suggestions. Responsibility for any remaining errors rests with the authors. The views expressed in this paper are those of the authors and are not necessarily those of the Reserve Bank of Australia. E-mail FinlayR@. 111 112 International Journal of Central Banking June 2012 yields of nominal and inflation-indexed zero-coupon bonds of equal maturity. That is yi T y T - yrt T .

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