NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Reverse Engineering the Yield Curve

David K. Backus, Stanley E. Zin

NBER Working Paper No. 4676
Issued in March 1994
NBER Program(s):   AP

Prices of riskfree bonds in any arbitrage-free environment are governed by a pricing kernel: given a kernel, we can compute prices of bonds of any maturity we like. We use observed prices of multi-period bonds to estimate, in a log-linear theoretical setting, the pricing kernel that gave rise to them. The high-order dynamics of our estimated kernel help to explain why first-order, one-factor models of the term structure have had difficulty reconciling the shape of the yield curve with the persistence of the short rate. We use the estimated kernel to provide a new perspective on Hansen-Jagannathan bounds, the price of risk, and the pricing of bond options and futures.

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