In this paper we report the currently employed term structure estimation method in the Bank of Finland and we also discuss interpretation of the final results it produces. First we will introduce 2 extensively utilized term structure estimation methods: the Cubic Spline Function method and the Nelson-Siegel approach. We assess their results, paying exclusive attention to the smoothness of forward interest rates and distribution of pricing errors. After that, we present the Bank of Finland’s approach, commenting on its pros and cons. Lastly, we talk about interpretation of the term structure of interest rates with focus on the inflation expectations and the role of the time-varying risk premia.
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One of the earliest issue in economic theory is the interperation of the term structure of interest rates. It continues to be acknowledged that the term structure of interest rates provides details regarding economic agent’s expectations about future interest rates, inflation rates and exchange rates.
Source: Research Discussion Papers, Bank of Finland
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