Estimating the Cost of U.S. Indexed Bonds

This paper presents an equilibrium bond pricing model driven by two stochastic factors: the real interest rate and the expected rate of inflation. The model’s parameters are estimated using a maximum likelihood technique based on a Kalman filter. Data on nominal U.S. Treasury securities and Survey of Professional Forecasters predictions of the GDP deflator are employed to identify the separate effects of real and nominal variables. The market prices of real interest rate risk and inflation risk are estimated, which allows us to construct yield curves for nominal and indexed U.S. Treasury securities. The relative costs of nominal and indexed bonds can then be assessed.