Decomposing the Israeli Term Structure of Interests Rates

This paper decomposes the Israeli term structure of interest rates into two parts: the expected path of real interest rates and the risk premia for 01/1985—12/2019. We carry out the estimation using a discrete-time essentially affine term structure model (ATSM). ATSM models are essentially reduced-form models: they assume that latent factors drive the economy, and are extensively used by major central banks to infer risk premia in the term structure. The results show that part of the decline in real yields since 1985 was accompanied by a substantial decrease in the real risk premium; the compensation investors require to hold government indexed-bonds has gone down substantially. The compensation has been as high as 3% for the 10-year real yield and has gone down to around zero in recent years. The inflation risk premium (an inflation compensation which is part of the nominal yield curve), has also shown a significant drop in recent years. The inflation risk premium has become slightly negative in recent years after being as high as 2.5% in early 2000 for the 10-year nominal yield.