October 2015

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.

Accessible materials (.zip)

Keywords: Long-run risk, economic uncertainty, term structure of interest rates, bond risk premium, variance risk premium, predictability, interest rate derivatives

DOI: http://dx.doi.org/10.17016/FEDS.2015.095

PDF: Full Paper

Back to Top
Last Update: June 19, 2020