Economic determinants of risk premia in the term structure of interest rates

A new empirical literature combining elements from macroeconomics and finance explains the dynamics of bond risk premia in terms of economic fundamentals. This permits to analyse jointly movements in yields and macroeconomic variables without assuming that risk premia are constant. A robust finding in the literature is that risk premia increase during recessions, presumably reflecting a more prudent attitude of investors. Correcting yields for risk premia helps in out-of-sample predictions. These models display a superior forecasting performance of future interest rates. Preliminary empirical results on euro area yields suggest that, compared to Germany during pre-EMU years, the variability of risk premia has declined after the introduction of the euro. JEL Classification: E4