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Professor of International Economics, Institute for International Economic Studies, Stockholm University; CEPR; and NBER. The first draft of the paper was written while the author was visiting the European I Department at the International Monetary Fund. He is grateful to the European I Department for its hospitality and productive environment. He has benefitted from discussions with and comments from Mårten Blix, Peter Clark, Martin Fetherston, Brian Hindley, Lars Hörngren, Desmond Lachman, Paul Masson, Donogh McDonald, Reza Moghadam, and Svante Öberg. The author is grateful to the Sveriges Riksbank for help with the data, and Mårten Blix for research assistance. The views expressed are the author’s alone and do not necessarily reflect the views of the IMF.
The analogy with average and marginal cost is exact when interest rates are continuously compounded, and when a zero-coupon yield curve is used. The analogy is approximate for coupon bond yield curves, and for annually compounded interest rates.
The continuously compounded spot rate i and the annually compounded spot rate ī (both measured in percent per year) are related by
The general case when the time to maturity is not an integer is handled in the Appendix. For semi-annual coupon payments, as in Britain and the United States, the formulas are accordingly modified (see for instance Fage (1986)).
A so-called par yield curve is an alternative way to unambiguously represent the term structure of interest rates.
Dahlquist and Svensson (1994) compares the original functional form of Nelson and Siegel (1987) to the much more complex functional form of Longstaff and Schwartz (1992) on Swedish data for the sample period December 1992-June 1993. The Nelson and Siegel functional form is much easier to use than the Longstaff and Schwartz functional form. The additional flexibility of the Longstaff and Schwartz functional form is not needed for that sample period. When additional flexibility is needed for a few trade dates in the longer sample in the present paper, the extended Nelson and Siegel functional form is chosen since it is much easier to use than the Longstaff and Schwartz functional form. Fisher, Nychka and Zervos (1994) have recently provided several important extensions to McCulloch’s cubic spline method.
Recall that the elasticity of the price with respect to one plus the yield is equal to the duration of a bond (the present value-weighted average maturity of coupon payments and face value).
The marginal lending rate was, through May 1994, the overnight rate at which banks could borrow reserves from the Riksbank. It can be seen as the Riksbank’s monetary policy instrument. Arbitrage by banks implied that the interbank overnight rate would be close to the marginal lending rate. From June 1, 1994, the Riksbank uses a system similar to that of Bundesbank, in that the repo rate, bounded by a floor (the deposit rate) and a ceiling (the lending rate) serves as the policy instrument.
See Shiller (1990) and Campbell and Shiller (1991). Fama and Bliss (1987) cannot, however, reject the expectations hypothesis for some combinations of settlement and maturity that are highly relevant for monetary policy, namely settlement in a few years and maturity one year later.
The forward term premium is the excess of the forward rate over the expected future spot rate. The holding period term premium is the excess of the expected holding period return on a long bond over the spot rate for the (usually rather short) holding period. The rollover term premium is the excess of the yield to maturity of a long bond over the expected return on rolling over a short bond to the long bond’s maturity date. See Shiller (1990) for details.
A theoretical discussion of the determinants of term, inflation and foreign exchange risk premia is provided in Svensson (1993b).
The marginal lending rate is normally quoted as a simple rate. For comparison across maturities, rates have to be compounded at the same frequency. For instance, continuously compounded or annually compounded rates can be used. Here annually compounded rates are used in all graphs. For a simple overnight interest rate of 11.5 percent per year, the corresponding annually compounded rate is about 0.7 percentage points per year higher. A simple rate i percent per year with maturity m years is related to the annually compounded rate ī percent per year according to
For the overnight rate, that is, for very small m, the simple rate ī is close to the continuously compounded rate i.
The Debt Office made a small issue of a 20-year indexed bond in April 1994. See further discussion in section 7.
After the British pound was floated on September 16, 1992, British long forward rates also increased dramatically, as documented in Bank of England (1993a,b) and Svensson (1994). British long forward rates did not reach pre-September 1992 levels until almost 12 months later.
See Svensson (1994) for a more detailed discussion of forward rates and monetary policy in these countries for the period between September 1992 and September 1993.
The nominal (real) term premium is the excess of the nominal (real) forward rate over the expected future nominal (real) spot rate.
A rather imperfect measure of inflation uncertainty, the standard deviation of answers to a Swedish inflation expectations survey further discussed below (Aragon (1994)), actually fell between February and May 1994.
is the column vector of partial derivatives with respect to the parameters, etc.