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Yield curve, time varying term premia, and business cycle fluctuations

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Modena, Matteo

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Abstract

Using data for U.S. and Canada, we find evidence of the time-varying nature of risk premia, which are obtained as difference between long term interest rates and their expected values. We then apply Kalman filtering to extract the conditional variance of term premia prediction errors; our results highlight that this variable is informative beyond term premia and spreads, and it significantly improves upon prediction capability of standard models. In particular, the conditional variance of term premia, reflecting the high volatility of financial markets, anticipates movements in the output growth. Empirical evidence supports the inverse correlation between term premia and business cycle fluctuations. Data suggest that a deterioration of financial markets conditions, as captured by the increased volatility of term premia, anticipates a decline in the output growth. Therefore, term premia conditional volatility has an adverse effect on the economy.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 8873.

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Date of creation: May 2008
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Handle: RePEc:pra:mprapa:8873

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Related research
Keywords: Term Structure Term Premia Kalman Filtering Industrial Production Growth

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Find related papers by JEL classification:
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
C01 - Mathematical and Quantitative Methods - - General - - - Econometrics

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