Institutions and the Term Structure of Interest Rates: A Unified Lucas-Tree and Affine Pricing

Heng-Fu Zou ()

No 788, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: This paper develops a unifed theoretical framework that integrates institutional quality into affine term structure models of interest rates. Building on a Lucas-tree economy with endogenous institutional capital, we derive the stochastic discount factor and show that zero-coupon bond prices admit an exponential-affine form. Using the Feynman-Kac representation, we obtain explicit Riccati equations and closed-form solutions under Vasicek- and CIR-type institutional dynamics. The analysis reveals how institutional persistence, mean reversion, and volatility affect the slope and curvature of the yield curve, generating distinct term premia across maturities. Comparative statics highlight that stronger and more stable institutions lower risk premia, while fragile or volatile institutions amplify borrowing costs. The framework bridges political economy and asset pricing, showing that institutional reforms not only promote long-run growth but also shape sovereign debt markets, financial development, and macroeconomic stability.

Keywords: Institutional capital; Affine term structure; Bond pricing; Lucas-tree model; Feynman-Kac formula; Vasicek model; CIR model; Sovereign yields; Political economy; Risk premia (search for similar items in EconPapers)
Pages: 15 pages
Date: 2025-08-21
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Persistent link: https://EconPapers.repec.org/RePEc:cuf:wpaper:788

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