Skip to main content
SpringerLink
Log in

How do zero-coupon inflation swaps predict inflation rates in the euro area? Evidence of efficiency and accuracy on 1-year contracts

  • Published:
Empirical Economics Aims and scope Submit manuscript

Abstract

This paper examines the risk-neutral efficient market hypothesis for inflation swap markets in the euro area from 2005.10 to 2014.07. Overall, we conclude that 1-year zero-coupon inflation swap rates are unbiased predictors of inflation rates. Further, there is no empirical evidence of an inflation risk premium and the assumption of rationality seems to hold. Definitely, these inferences encourage the reading of inflation expectations embedded in short-term inflation swaps. Additionally, we compare the predictive ability of inflation swaps with other measures of inflation expectations. The in-sample results show that, in contrast with surveys, market-based measures are able to accurately forecast inflation rates. In turn, based on an out-of-sample analysis, a straightforward econometric model dominates other sources. Therefore, a combined analysis that uses different sources contributes to a more robust view of future inflation rates.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1

Similar content being viewed by others

Notes

  1. It should be noted that the data on ZCISR date back to June 2004. If we consider contracts with longer maturities, we have a reduced number of observations to test the EMH. However, an empirical work with a reduced sample is pointless since it does not allow us to draw robust conclusions. In view of this constraint, concentrating the analysis on short-term contracts is a standard practice (see, e.g., Casiraghi and Miccoli 2015).

  2. The results of the different studies may not be directly comparable owing to differences in sample periods, instruments and methods used (Grishchenko and Huang 2013; Bekaert and Wang 2010). Though, it can also be an indication that the inflation risk premium is time-varying, depending on the inflation level and on the uncertainty about future inflation rates.

  3. Deacon et al. (2004), Kerkhof (2005) and García and van Rixtel (2007) are examples of authors who provide information on the evolution, size and composition of the inflation derivative market.

  4. Theoretically, in a frictionless world where agents are endowed with rational expectations and there are no risk premia, inflation expectations taken from inflation swaps and other inflation-linked instruments should be similar and discrepancies among alternative measures are supposed to be quickly adjusted. Otherwise, any difference of this kind constitutes an arbitrage opportunity that can be exploited by agents who have access to the diverse markets. In practice, on the back of the failure of these principles and other technicalities, some instruments may be more prone to generate better forecasts.

  5. So, a potential failure of the risk-neutral EMH can be due to the presence of a risk premium or to a failure of rational expectations. Also, it is necessary to admit the possibility of information inefficiencies as well as a possible disagreement on inflation expectations. Furthermore, one may conjecture a supply-demand imbalance in the inflation swap market. All these factors may cause inefficiencies in inflation swap markets and speculators may exploit them by operating simultaneously in the swap market and in other markets for inflation-linked securities.

  6. To lighten the notation, we ignore the inflation lag of l months in all formulas. Nonetheless, all calculations take into account the three-month lag that is the usual convention for euro area inflation swaps.

  7. When analyzing regression (4) one should have in mind the concept of speculative efficiency which postulates that a market is speculatively efficient if excess returns from speculation are not economically significant. Therefore, in practice, \(\alpha \) and \(\beta \) do not always have to correspond to the standard values under the null hypothesis and deviations from these figures might occur as long as these do not allow for large profit opportunities (Wagner 2012).

  8. Surveys correspond to the most direct source of inflation expectations since they put specific questions to particular groups designed for this purpose. Thus, results are directly observed rather than estimated or inferred. For the euro area, various survey-based measures of inflation expectations are available. Since the ECB SPF is one of the main focus of attention (it is free, provides point forecasts of inflation expectations at various horizons and also offers a quantitative assessment of uncertainty surrounding the reported point forecasts), we favor this source. Given that the ECB SPF is conducted on a quarterly basis, we convert these data into monthly series via linear interpolations.

  9. Market-based measures of inflation expectations have the advantage of being forward looking, timely and frequently updated for a wide range of maturities, summarizing the view of market participants that are willing to risk money based on their beliefs. Besides the use of inflation swaps, the simplest way to measure expected inflation by means of financial data is to consider information on BEIR that, even in the case of comprising some risk premia, are broadly determined by expectations of future inflation rates (see, e.g., Strohsal and Winkelmann 2015). In the derivation of euro area inflation expectations from BEIR we draw on bonds issued by the French Treasury taking into consideration (1) the date of the first issuance and the consequent data availability to proceed with the empirical analysis; (2) the number of inflation-linked bonds and large range of maturities; (3) the amount outstanding available in the market and the higher degree of liquidity; (4) creditworthiness concerns (non-peripheral States).

  10. In particular, if the two components are orthogonal, the decomposition is exact.

  11. It is reasonable to consider that investors base their expectations on this source since it corresponds to one of the most direct measures of inflation expectation (with real-time updates). In this line, Bernanke (2004) states that “inflation-indexed securities would appear to be the most direct source of information about inflation expectations and real interest rates”.

  12. It is not strictly correct to interpret this coefficient as a departure from risk neutrality because \(\beta ^{RP}\) will be null if there is a constant risk premium. Indeed, in the case that the risk premium is constant, \(\rho _t =\rho \) and, consequently, \(\hbox {var}\left( {\rho _t } \right) =\hbox {var}\left( \rho \right) =0\). In this special situation: \(\beta =1\). This fact underlines the importance of the complete evaluation of the EMH beyond the simple validation of the unbiasedness hypothesis.

  13. Caparole et al. (2012) realize that inflation uncertainty has declined steadily since the inception of euro area, while short-run uncertainty has stabilized.

  14. Considering data on the US market, Fleming and Sporn (2014) conclude that the ZCIS market is reasonably liquid and transparent. In this sense, knowing that the euro area has the most active inflation swap market, the concerns about liquidity should be even smaller, especially for maturities with a higher negotiation.

  15. As is standard for swaps contracts, there are no up-front costs to either party of entering into the contract. In addition, as mentioned by Schulz and Stapf (2014), collateralization mitigates the problem of credit risk and has become increasingly popular among OTC derivatives during the last years.

  16. In effect, this result provides compelling evidence that the assumptions underlying the financial theory hold since, in a context with perfect markets, it is expected a substitution between BEIR and ZCISR and, as a result, inflation curves derived from both instruments should be identical. Against this backdrop, several authors have been studying the relationship between inflation expectations extracted from inflation swaps and inflation-bond markets (see e.g., Devlin and Patwardhan 2012; Schulz and Stapf 2014; Grothe and Meyler 2015).

  17. Based on expression (14) the coefficient \(\varphi \) corresponds to the deviation of the risk-neutral EMH due to systematic expectational errors. So, regression (19) will allow us to check if the value found for \(\beta ^{RE}\) is statistically different from zero.

  18. In practice, regressions (21) and (23) are estimated taking into account information from time \(t-1\) because, at moment t, agents only know the realized inflation rate and the rational expectations forecast errors of the previous month.

  19. Similar tests with other variables known at the time that inflation swaps are traded provide analogous conclusions.

  20. Using the time series plot of ACF and PACF to determine the order of the SARMA model, we select a SARMA (1,1) (1,1)\(_{12}\) as an appropriate specification to forecast euro area inflation.

  21. Timmermann and Granger (2004) study the relationship between the forecasting activity and the EMH, documenting that the practice of searching for predictable patterns and exploiting trading opportunities affects market prices. In consequence, stable forecasting patterns are unlikely to persist for long periods of time and will self-destruct when discovered by a large number of agents.

References

  • Andolfatto D, Hendry S, Moran K (2008) Are inflation expectations rational? J Monet Econ 55(2):406–422

    Article  Google Scholar 

  • Ang A, Bekaert G, Wei M (2007) Do macro variables, asset markets, or surveys forecast inflation better? J Monet Econ 54(4):1163–1212

    Article  Google Scholar 

  • Ang A, Bekaert G, Wei M (2008) The term structure of real rates and expected inflation. J Financ 63(2):797–849

  • Aucremanne L, Collin M, Stragier T (2007) Assessing the gap between observed and perceived inflation in the euro area: is the credibility of the HICP at stake? Working paper No. 112, National Bank of Belgium

  • Ball L, Croushore D (2003) Expectations and the effects of monetary policy. J Money Credit Bank 35(4):473–484

  • Beechey MJ, Johannsen BK, Levin AT (2011) Are long-run inflation expectations anchored more firmly in the euro area than in the United States? Am Econ J Macroecon 3(2):104–129

    Article  Google Scholar 

  • Bekaert G, Wang XS (2010) Inflation risk and the inflation risk premium. Econ Policy 25(64):755–806

    Article  Google Scholar 

  • Berk JM, Hebbink G (2006) The anchoring of European inflation expectations. Working paper No. 116, Netherlands Central Bank

  • Bernanke B (2004) What policymakers can learn from asset prices. In: Speech before the investment analyst society of Chicago. http://www.federalreserve.gov/boarddocs/speeches/2004/20040415/default.htm

  • Bowles C, Friz R, Genre V, Kenny G, Meyler A, Rautanen T (2007) The ECB survey of professional forecasters (SPF): a review after eight years’ experience. Occasional paper series No. 59, European Central Bank

  • Buraschi A, Jiltsov A (2005) Inflation risk premia and the expectation hypothesis. J Financ Econ 75(2):429–490

  • Capistrán C, Timmermann A (2009) Disagreement and biases in inflation expectations. J Money Credit Bank 41(2–3):365–396

    Article  Google Scholar 

  • Caparole GM, Onorante L, Paesani P (2012) Inflation and inflation uncertainty in the euro area. Empir Econ 43(2):597–615

    Article  Google Scholar 

  • Carroll CD (2003) Macroeconomic expectations of households and professional forecasters. Q J Econ 118(1):269–298

    Article  Google Scholar 

  • Casiraghi M, Miccoli M (2015) Risk-adjusted expectations of inflation. Questioni di Economia e Finanza (Occasional papers) No. 286, Bank of Italy

  • Chen R-R, Liu B, Cheng X (2010) Pricing the term structure of inflation risk premia: theory and evidence from TIPS. J Empir Financ 17(4):702–721

    Article  Google Scholar 

  • Cheung YW (1993) Exchange rate risk premiums. J Int Money Financ 12(2):182–194

    Article  Google Scholar 

  • Christensen J, Lopez J, Rudebusch G (2010) Inflation expectations and risk premiums in an arbitrage-free model of nominal and real bond yields. J Money Credit Bank 42(6):143–178

    Article  Google Scholar 

  • Chu QC, Lee CF, Pittman DN (1995) On the inflation risk premium. J Bus Financ Acc 22(6):881–892

    Article  Google Scholar 

  • D’Amico S, Kim DH, Wei M (2010) Tips from TIPS: the international content of treasury inflation-protected security prices. Finance and Economics discussion series 2010–2019, Federal Reserve Board

  • Deacon M, Derry A, Mirfendereski D (2004) Inflation-indexed securities: bonds, swap and other derivatives. Wiley, Hoboken

    Book  Google Scholar 

  • Devlin W, Patwardhan D (2012) Measuring market inflation expectations. Econ Round Up 2:5–17

    Google Scholar 

  • Diebold FX, Mariano RS (1995) Comparing predictive accuracy. J Bus Econ Stat 13(3):253–263

    Google Scholar 

  • Ejsing J, García JA, Werner T (2007) The term structure of euro area break-even inflation rates: the impact of seasonality. Working paper No. 830, European Central Bank

  • European Central Bank (2011) Inflation expectations in the euro area: a review of recent developments. Monthly Bulletin

  • Fama EF (1984) Forward and spot exchange rates. J Monet Econ 14(2):319–338

    Article  Google Scholar 

  • Fleming MJ, Sporn JR (2014) Trading activity and price transparency in the inflation swap market. Econ Policy Rev 19(1):45–58

    Google Scholar 

  • Forsells M, Kenny G (2004) Rationality and the dynamics of euro area inflation survey expectations. J Bus Cycle Meas Anal 1(1):13–41

    Google Scholar 

  • Froot KA, Frankel JA (1989) Forward discount bias: is it an exchange risk premium? Q J Econ 104(1): 139–161

  • García JA, Manzanares A (2007) Reporting biases and survey results: evidence from European professional forecasters. Working paper No. 836, European Central Bank

  • García JA, van Rixtel A (2007) Inflation-linked bonds from a central bank perspective. Occasional paper series No. 62, European Central Bank

  • García JA, Werner T (2010) Inflation risk and inflation risk premia. Working paper No. 1162, European Central Bank

  • Galati G, Poelhekke S, Zhou C (2011) Did the crisis affect inflation expectations? Int J Cent Bank 7(1):167–207

    Google Scholar 

  • Genre V, Kenny G, Meyler A, Timmermann A (2013) Combining expert forecasts: can anything beat the simple average? Int J Forecast 29(1):108–121

    Article  Google Scholar 

  • Golden J, Adams A, Liu Z, Sorensen S (2010) Forecasting UK inflation: an empirical analysis. Working paper, Heriot-Watt University

  • Gramlich EM (1983) Models of inflation expectations formation: a comparison of household and economist forecasts. J Money Credit Bank 15(2):155–173

    Article  Google Scholar 

  • Grishchenko OV, Huang J-Z (2013) Inflation risk premium: evidence from the TIPS market. J Fixed Income 22(4):5–30

    Article  Google Scholar 

  • Grothe M, Meyler A (2015) Inflation forecasts: are market-based and survey-based measures informative?. European Central Bank, Frankfurt

    Google Scholar 

  • Harvey DI, Newbold P (2000) Tests for multiple forecast encompassing. J Appl Econ 15(5):471–482

    Article  Google Scholar 

  • Haubrich J, Pennacchi G, Ritchken P (2011) Estimating real and nominal term structures using treasury yields, inflation, inflation forecasts, and inflation swap rates. Working paper No. 11–07, Federal Reserve Bank of Cleveland

  • Hördahl P, Tristani O (2007) Inflation risk premia in the term structure of interest rates. Working paper series No. 734, European Central Bank

  • Hördahl P, Tristani O (2014) Inflation risk premia in the euro area and the United States. Int J Cent Bank 10(3):1–47

    Google Scholar 

  • Hurd M, Relleen J (2006) New information from inflation swaps and index-linked bonds. Bank Engl Q Bull 46(1):24–34

    Google Scholar 

  • Joyce M, Lildholdt P, Sorensen S (2010) Extracting inflation expectations and inflation risk premia from the term structure: a joint model of the UK nominal and real yield curves. J Bank Financ 34(2):281–294

    Article  Google Scholar 

  • Kajuth F, Watzka S (2011) Inflation expectations from index-linked bonds: correcting for liquidity and inflation risk premia. Q Rev Econ Financ 51(3):225–235

    Article  Google Scholar 

  • Kerkhof J (2005) Inflation derivatives explained: markets, products, and pricing, fixed income, quantitative research. Lehman Brothers, New York

    Google Scholar 

  • Lahiri K, Sheng X (2008) Evolution of forecast disagreement in a Bayesian learning model. J Econ 144(2):325–340

    Article  Google Scholar 

  • Mankiw NG, Reis R, Wolfers J (2004) Disagreement about inflation expectations. NBER Macroecon Annu 18(1):209–248

    Google Scholar 

  • Mestre R (2007) Are survey-based inflation expectations in the euro area informative? Working paper series No. 721, European Central Bank

  • Muth JF (1961) Rational expectations and the theory of price movements. Econometrica 29(3):315–335

    Article  Google Scholar 

  • Newey WK, West KD (1987) A simple positive semi-definite heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica 55(3):703–708

    Article  Google Scholar 

  • Pesaran H (1989) The limits to rational expectations. Blackwell, Oxford

    Google Scholar 

  • Roberts JM (1997) Is inflation sticky? J Monet Econ 39(2):173–196

    Article  Google Scholar 

  • Romer C, Romer D (2000) Federal reserve information and the behavior of interest rates. Am Econ Rev 90(3):429–457

    Article  Google Scholar 

  • Strohsal T, Winkelmann L (2015) Assessing the anchoring of inflation expectations. J Int Money Financ 50:33–48

    Article  Google Scholar 

  • Schulz A, Stapf J (2014) Price discovery on traded inflation expectations: does the financial crisis matter? Eur J Financ 20(11):1037–1063

    Article  Google Scholar 

  • Timmermann A, Granger CWJ (2004) Efficient market hypothesis and forecasting. Int J Forecast 20(1):15–27

    Article  Google Scholar 

  • Trehan B (2015) Surveys measures of expected inflation and the inflation process. J Money Credit Bank 47(1):207–222

    Article  Google Scholar 

  • Wagner C (2012) Risk-premia, carry-trade dynamics, and economic value of currency speculation. J Int Money Financ 31(5):1195–1219

    Article  Google Scholar 

  • Wolff CCP (1987) Forward foreign exchange rates, expected spot rates, and premia: a signal-extraction approach. J Financ 42(3):395–406

    Google Scholar 

Download references

Acknowledgements

We thank two anonymous referees for their constructive comments.

Author information

Authors and Affiliations

  1. Economics and Research Department, Banco de Portugal, Av. Almirante Reis, 71, 6th Floor, 1150-012, Lisbon, Portugal

    Pedro Pires Ribeiro

  2. Instituto Universitário de Lisboa, ISCTE–IUL, UNIDE, Complexo INDEG/ISCTE, Av. Prof. Aníbal Bettencourt, 1600-189, Lisbon, Portugal

    Pedro Pires Ribeiro & José Dias Curto

Authors
  1. Pedro Pires Ribeiro
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. José Dias Curto
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to José Dias Curto.

Additional information

Disclaimer The views expressed are those of the authors and do not necessarily represent those of the Banco de Portugal or the Eurosystem.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Ribeiro, P.P., Curto, J.D. How do zero-coupon inflation swaps predict inflation rates in the euro area? Evidence of efficiency and accuracy on 1-year contracts. Empir Econ 54, 1451–1475 (2018). https://doi.org/10.1007/s00181-017-1268-8

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s00181-017-1268-8

Keywords

JEL Classification

Search

Navigation