Real term structure estimation

ESTIMATING THE REAL TERM STRUCTURE OF INTEREST RATES... 

The drawbacks of each of these approaches are apparent. A rather more valid and sound approach is to constmct a term structure of the real interest rates, which would indicate, in exactly the same way that the conventional forward rate curve does for nominal rates, the market s expectatimis rat future inflation rates. In countries where there are liquid markets in both conventional and inflation-indexed bmids, we can observe a nominal and a real yield curve. It then becomes possible to estimate both a conventional and a real term structure using these allows us to create pairs of hypothetical conventional and indexed bonds that have identical maturity dates, for any point on the term structure. We could then apply the break-even approach to any pair of bonds... 

In this section, we review one method that can be used to estimate and fit a real term structure. 

Using the prices of index-linked bonds, it is possible to estimate a term structure of real interest rates. The estimation of such a curve provides a real interest counterpart to the nominal term structure that was discussed in the previous chapters. More important it enables us to derive a real forward rate curve. This enables the real yield curve to be used as a somce of information on the market s view of expected future inflation. In the United Kingdom market, there are two factors that present problems for the estimation of the real term structure the first is the 8-month lag between the indexation uplift and the cash flow date, and the second is the fact that there are fewer index-linked bonds in issue, compared to the number of conventional bonds. The indexation lag means that in the absence of a measure of expected inflation, real bond yields are dependent to some extent on the assumed rate of future inflatiOTi. The second factor presents practical problems in curve estimation in December 1999 there were only 11 index-linked gilts in existence, and this is not sufficient for most models. Neither of these factors presents an insurmountable problem however, and it is stiU possible to estimate a real term structure. 

On the other hand, the Hoar Committee s estimate for the UK did not include some significant factors, and some costs that were considered have increased in real terms since the estimates were made. Larger plants and structures are more common, and even when there is no increase in size more intensive use of equipment is demanded. As a result, the real cost of downtime or unavailability, and of dislocation to users of, for example, motorway viaducts while repairs are made, have increased appreciably. Moreover, maintenance and rectification are labour intensive activities, and hence particularly susceptible to the effects of inflation. The increases probably outweigh the savings mentioned, and the current cost of corrosion in the UK is probably around 4% of GNP. As future savings depend on the improvement being maintained despite pressures to reduce first costs, a sound economic approach to corrosion is no less important than it was in 1970. 

Observing the trading patterns of a liquid market in inflation-indexed bonds enables analysts to draw conclusions about nominal versus real interest rates and to construct an inflation term structure. Such analysis is problematic, since conventional and indexed bonds typically differ considerably in liquidity. Nevertheless, as explained above, it is usually possible to infer market estimates of inflation expectations from the difference between the yields of the two types of bonds. 

Another set of terms considered by Eyring, et al. consisted of structures having a double bond between carbons. These should be expected to be involved to some small extent—small because they have one less real bond. This is essentially invoking hyperconjugation. These authors did not reach a definite conclusion regarding the importance of these structures and decided that they probably would stabilize the eclipsed configuration, which was not known at that time to be the incorrect one. It is still not simple to make a reliable estimate of the importance of this contribution. 

Since N p is exactly determined from the structure of the repeat unit, it is only necessary to develop a new correlation for J. The fixed term 4.2N p is usually a large portion (sometimes the dominant portion) of K, which is the quantity of real physical interest for estimating [r ] . 

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