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

Georges Prat and Remzi Uctum

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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 3and 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; term structure; risk premium (search for similar items in EconPapers)
Date: 2021
New Economics Papers: this item is included in nep-cba, nep-isf, nep-rmg and nep-upt
Note: View the original document on HAL open archive server: https://hal.science/hal-03319099
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Published in Journal of Economic Behavior and Organization, 2021, 182, pp.421-436. ⟨10.1016/j.jebo.2019.09.006⟩

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Related works:
Journal Article: 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:hal:journl:hal-03319099

DOI: 10.1016/j.jebo.2019.09.006

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