October 2007

Implied Interest Rate Skew, Term Premiums, and the "Conundrum"

J. Benson Durham


The skew, irrespective of the mean and variance, of investors' interest rate expectations may affect required bond yields over expected short rates. Indeed, evidence suggests that the near-term skew of the option-implied distribution of expected short-term interest rates correlates with distant-horizon term premiums, as derived from a latent-factor affine term structure model (ATSM). Reduced-form models that include skew generally fit the data well and actually better "explain" variation in the term premium during the so-called "conundrum" than during other periods of the May 1989 to May 2006 sample. Moreover, estimates suggest that skew accounts for over half of the movement in term premiums during the "conundrum," considerably more than any other correlate. Caveats regard the term structure of skew as well as alternative measures of the term premium. Indeed, regression analysis of movements in term premiums is plagued by specification bias on both the left- and right-hand-side of the equation.

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Keywords: Implied skew, term premiums, affine term structure model, conundrum

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