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The Term Structure of Real Interest Rates: Theory and Evidence from the U.K. Index-Linked Bonds

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Author Info
Juha Ilmari Seppala (University of Chicago)

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Abstract

This paper argues that a simple general equilibrium model can explain two of the most persistent term structure puzzles. First, Donaldson, Johnsen, and Mehra (1990) show that while in the U.S. nominal term structure the interest rates are pro-cyclical and term spreads counter-cyclical the stochastic growth model predicts that the interest rates are counter-cyclical and term spreads pro-cyclical. The resolution of this puzzle is simple. Using the data on the U.K. index-linked bonds, I show that during the sample period 1984:1--1995:8 the (ex-ante) real interest rates were counter-cyclical and term spreads pro-cyclical. Second, according to Backus, Gregory, and Zin (1989) a complete markets model can account for neither the sign nor the magnitude of average risk premiums in forward prices. This paper applies recent research by Alvarez and Jermann (1999ab) to the term premium puzzle. It is shown that the model produces a large risk premium with the correct sign, and unlike the complete markets model can generate enough variation in the risk premia to account for the rejections of the expectations hypothesis. In addition, when the model is calibrated to the U.K. aggregate and household data, the regressions of future spot rates and consumption growth on the term spread behave in a similar manner both in simulated and in actual data. Keywords: Business Cycles, Term Structure of Interest Rates, General Equilibrium, Risk Premia.

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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 0245.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:0245

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  1. Scheffel, Eric, 2008. "A Credit-Banking Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Cardiff Economics Working Papers E2008/30, Cardiff University, Cardiff Business School, Economics Section. [Downloadable!]
  2. Juha Ilmari Seppala, 2000. "Asset Prices and Business Cycles Under Limited Commitment," Econometric Society World Congress 2000 Contributed Papers 0244, Econometric Society. [Downloadable!]
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