Restrictions on Risk Prices in Dynamic Term Structure Models

Michael Bauer

No 2011-03, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: Restrictions on the risk-pricing in dynamic term structure models (DTSMs) tighten the link between cross-sectional and time-series variation of interest rates, and make absence of arbitrage useful for inference about expectations. This paper presents a new econometric framework for estimation of affine Gaussian DTSMs under restrictions on risk prices, which addresses the issues of a large model space and of model uncertainty using a Bayesian approach. A simulation study demonstrates the good performance of the proposed method. Data for U.S. Treasury yields calls for tight restrictions on risk pricing: only level risk is priced, and only changes in the slope affect term premia. Incorporating the restrictions changes the model-implied short-rate expectations and term premia. Interest rate persistence is higher than in a maximally-flexible model, hence expectations of future short rates are more variable--restrictions on risk prices help resolve the puzzle of implausibly stable short-rate expectations in this literature. Consistent with survey evidence and conventional macro wisdom, restricted models attribute a large share of the secular decline in long-term interest rates to expectations of future nominal short rates.

Keywords: Bonds - Prices; Interest rates (search for similar items in EconPapers)
Pages: 36 pages
Date: 2011
New Economics Papers: this item is included in nep-cis, nep-mon and nep-upt
Note: ∗Previous versions of this paper were circulated under the titles “Bayesian Estimation of Dynamic Term Structure Models under Restrictions on Risk Pricing” and “Term Premia and the News.”
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Citations: View citations in EconPapers (17)

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Related works:
Journal Article: Restrictions on Risk Prices in Dynamic Term Structure Models (2018)
Working Paper: Restrictions on Risk Prices in Dynamic Term Structure Models (2015)
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