Inflation Ambiguity and the Term Structure of Arbitrage-free U.S. Government Bonds
Expected inflation plays a very important role in the pricing of nominal bonds. Data evidence confirms that investors are confronted with a set of multiple priors on expected inflation. This set has been large and volatile during the 1970s and early 1980s and low during the 1990s. I show that low risk aversion together with low inflation ambiguity aversion can explain the term premium in U.S. Government bonds. The equilibrium has two inflation premiums, an inflation risk premium and an inflation ambiguity premium. The inflation ambiguity premium is upward sloping and peaked during the mid 1970s and early 1980s.
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