Finance and Economics Discussion Series (FEDS)
Term Structure of Interest Rates with Short-run and Long-run Risks
Olesya Grishchenko, Zhaogang Song, and Hao Zhou
Bond returns are time-varying and predictable. What economic forces drive this variation? To answer this long-standing question, we propose a consumption-based model with recursive preferences, long-run risks, and inflation non-neutrality. Our model offers two important insights. First, our model matches well the post-1990 nominal upward-sloping U.S. Treasury yield curve. Second, consistent with our model's implication, variance risk premium based on the U.S. interest rate derivatives data emerges as a strong predictor for short-horizon Treasury excess returns, above and beyond the predictive power of other popular factors. In the model equilibrium, the variance risk premium is related to the short-run risks in the economy, while standard forward-rate-based factors are associated with long-run risks in the economy.
Keywords: Long-run risk, economic uncertainty, term structure of interest rates, bond risk premium, variance risk premium, predictability, interest rate derivatives
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