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Macro-finance VARs and bond risk premia: a caveat

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Author Info
Taboga, Marco

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Abstract

Around the turn of the Twentieth century, US and euro area long-term bond yields experienced a remarkable decline and remained at historically low levels even in the face of rising short-term rates (the so called "conundrum"). This unusual phenomenon has been analyzed by many researchers through the lens of macro-finance VARs and no-arbitrage term structure models. A commonly found result is that the decline in long-term rates was primarily driven by an unprecedented reduction in risk premia. I show that such result might be an artefact of the class of models employed to study the phenomenon. I propose an alternative model which suggests that, although risk premia played an important role in reducing bond yields, other two equally important forces were at play, i.e. a decline in the real natural rate of interest and a structural reduction in inflation expectations. I conclude that, after accounting for permanent shifts in the expectations about the future path of short-term rates, the dynamics of risk premia observed after the turn of the century have not been unusual if considered from an historical perspective.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 11585.

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Date of creation: 14 Nov 2008
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Handle: RePEc:pra:mprapa:11585

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Related research
Keywords: Bond yields; forward premia; macro-finance models.;

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Find related papers by JEL classification:
E0 - Macroeconomics and Monetary Economics - - General
C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  1. Marcello Pericoli & Marco Taboga, 2008. "Canonical Term-Structure Models with Observable Factors and the Dynamics of Bond Risk Premia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(7), pages 1471-1488, October. [Downloadable!] (restricted)
  2. David K. Backus & Jonathan H. Wright, 2007. "Cracking the Conundrum," Working Papers 07-22, New York University, Leonard N. Stern School of Business, Department of Economics. [Downloadable!]
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  3. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May. [Downloadable!] (restricted)
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  4. Froot, Kenneth A, 1989. " New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(2), pages 283-305, June. [Downloadable!] (restricted)
  5. Kim, Don H. & Orphanides, Athanasios, 2005. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," CEPR Discussion Papers 5341, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October. [Downloadable!] (restricted)
  7. Friedman, Benjamin M., 1980. "Survey evidence on the `rationality' of interest rate expectations," Journal of Monetary Economics, Elsevier, vol. 6(4), pages 453-465, October. [Downloadable!] (restricted)
  8. Tao Wu & Glenn Rudebusch, 2004. "A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy," 2004 Meeting Papers 104, Society for Economic Dynamics. [Downloadable!]
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  9. Evans, Charles L. & Marshall, David A., 1998. "Monetary policy and the term structure of nominal interest rates: Evidence and theory," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 53-111, December. [Downloadable!] (restricted)
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  10. Thomas Laubach & John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics, MIT Press, vol. 85(4), pages 1063-1070, November. [Downloadable!] (restricted)
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  11. Gabriel Fagan & Jérôme Henry & Ricardo Mestre, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 42, European Central Bank. [Downloadable!]
  12. Hordahl, Peter & Tristani, Oreste & Vestin, David, 2006. "A joint econometric model of macroeconomic and term-structure dynamics," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 405-444. [Downloadable!] (restricted)
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  13. Ang, Andrew & Piazzesi, Monika & Wei, Min, 2006. "What does the yield curve tell us about GDP growth?," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 359-403. [Downloadable!] (restricted)
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