The Long-run Risk Model: Dynamics and Cyclicality of Interest Rates

Henrik Hasseltoft ()
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Henrik Hasseltoft: Swedish Institute for Financial Research, Postal: Saltmätargatan 19A, SE-113 59 Stockholm, Sweden

No 58, SIFR Research Report Series from Institute for Financial Research

Abstract: This paper shows that the long-run risk model of Bansal and Yaron (2004) is able to simultaneously explain the dynamics and cyclical properties of interest rates and the level and volatility of equity returns. Specifically, the model accounts for deviations from the expectations hypothesis of interest rates, the upward sloping nominal yield curve, the downward sloping term structure of volatility and the predictive power of the yield spread. Real (nominal) rates are positively (negatively) correlated with consumption growth and the nominal yield spread predicts future real consumption growth, excess stock returns and inflation. The cyclical properties of nominal interest rates are shown to critically depend on the value of the elasticity of intertemporal substitution and on the correlation between consumption and inflation. The driving forces of the model are uncertainty about expected consumption growth, time-varying volatility of consumption growth and deviations from the Fisher hypothesis.

Keywords: long run risk; cyclicality; interest rates (search for similar items in EconPapers)
JEL-codes: E43 G12 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2007-07-15
New Economics Papers: this item is included in nep-mac, nep-mon and nep-rmg
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