Term Structure of Interest Rates with Short-run and Long-run Risks

Grishchenko, Olesya V.; Song, Zhaogang; Zhou, Hao

doi:10.17016/FEDS.2015.095

Working Paper

Term Structure of Interest Rates with Short-run and Long-run Risks

Abstract: 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 premiums; variance risk premium; predictability; interest rate derivatives; ;

https://doi.org/10.17016/FEDS.2015.095