Uncertainty and the price of risk in a nominal convergence process

Abstract

In this paper we decompose nominal interest rates into real risk-free rates, inflation expectations and risk premia using an affine model that takes as factors the observed inflation rate and the parameters generated in the zero yield curve estimation. We apply this model to the Spanish economy during the 90s, which is an especially challenging exercise given the nominal convergence towards the European Monetary Union (EMU) then under way. The methodology seems to be suitable for other countries currently involved in convergence towards EMU. The evidence indicates that inflation expectations and risk premia account for most of the observed variation in nominal rates, while real risk free interest rates show a reduction during this period lower than that suggested by other approaches