Bond Risk, Bond Return Volatility, and the Term Structure of Interest Rates

This paper proposes a term structure of interest rates model that modifies and extends the Campbell and Cochrane (1999) surplus consumption framework. The distinguishing contributions are tractable, continuous-time analytical solutions for the term structure of interest rate generating a realistic upward sloping yield curve. Despite the focus on the term structure, the model matches plausible equity quantities. For the interest rate, the model is able to account for the moments of bond yields at numerous maturities and produce countercyclical bond risk premia as seen in the data. Moreover, the model captures reasonable time series fluctuation on real interest rates. However, the model has difficulties reproducing empirical deviations from the expectations hypothesis.

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A Preferred‐Habitat Model of the Term Structure of Interest Rates

Econometrica ◽

10.3982/ecta17440 ◽

2021 ◽

Vol 89 (1) ◽

pp. 77-112 ◽

Cited By ~ 3

Author(s):

Dimitri Vayanos ◽

Jean-Luc Vila

Keyword(s):

Interest Rates ◽

Term Structure ◽

Large Scale ◽

Relative Effect ◽

Habitat Model ◽

Bond Risk Premia ◽

Forward Guidance ◽

Preferred Habitat ◽

Asset Purchases ◽

Bond Risk

We model the term structure of interest rates that results from the interaction between investors with preferences for specific maturities and risk‐averse arbitrageurs. Shocks to the short rate are transmitted to long rates through arbitrageurs' carry trades. Arbitrageurs earn rents from transmitting the shocks through bond risk premia that relate positively to the slope of the term structure. When the short rate is the only risk factor, changes in investor demand have the same relative effect on interest rates across maturities regardless of the maturities where they originate. When investor demand is also stochastic, demand effects become more localized. A calibration indicates that long rates underreact to forward‐guidance announcements about short rates. Large‐scale asset purchases can be more effective in moving long rates, especially if they are concentrated at long maturities.

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