Restrictions on Risk Prices in Dynamic Term Structure Models

Michael Bauer

Journal of Business & Economic Statistics, 2018, vol. 36, issue 2, 196-211

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 article 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. Supplementary materials for this article are available online.

Date: 2018
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Citations: View citations in EconPapers (21)

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Related works:
Working Paper: Restrictions on Risk Prices in Dynamic Term Structure Models (2015)
Working Paper: Restrictions on Risk Prices in Dynamic Term Structure Models (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:taf:jnlbes:v:36:y:2018:i:2:p:196-211

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DOI: 10.1080/07350015.2016.1164707

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