Term structure of interest rates: Modelling the risk premium using a two horizons framework

Georges Prat and Remzi Uctum

Journal of Economic Behavior & Organization, 2021, vol. 182, issue C, 421-436

Abstract: We propose a two-horizon interest rate term structure model where the maturity of the riskless rate is the one of the debt security whose duration equals investor's desired horizon. Our framework thus relaxes the usual assumptions of the literature that the riskless rate is unchangingly the short period rate. A representative investor compares at each of the 3- and the 6-month horizons the risk premium offered by the market and the one they require to take a risky position, the latter premium being determined by the portfolio choice theory. Due to market frictions, the deviation between the offered and required risk premium evolves according to a mean-reverting process. Using 3-month ahead survey-based expectations of the US 3-month Treasury Bill rate, we employ Kalman filtering to estimate the market risk premium where the preference parameter of investors for alternative horizons is time-varying. We find that the market comprises both a group of agents with 3-month preferred horizon and a group of agents with 6-month preferred horizon with a weigh of two-thirds for the first group.

Keywords: Interest rates; Risk premium; Survey data (search for similar items in EconPapers)
JEL-codes: C51 D84 E43 G11 G14 (search for similar items in EconPapers)
Date: 2021
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Related works:
Working Paper: Term structure of interest rates: modelling the risk premium using a two horizons framework (2021)
Working Paper: Term structure of interest rates: modelling the risk premium using a two horizons framework (2018)
Working Paper: Term structure of interest rates: modelling the risk premium using a two-horizons framework (2018)
Working Paper: Term structure of interest rates: modelling the risk premium using a two-horizons framework (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jeborg:v:182:y:2021:i:c:p:421-436

DOI: 10.1016/j.jebo.2019.09.006

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