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Consumption volatility risk and the inversion of the yield curve

Author

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  • Adriana Grasso

    (LUISS Guido Carli)

  • Filippo Natoli

    (Bank of Italy)

Abstract

We propose a consumption-based model that allows for an inverted term structure of real and nominal risk-free rates. In our framework the agent is subject to time-varying macroeconomic risk, and interest rates at all maturities depend on her risk perception, which shapes saving propensities over time. In bad times, when risk is perceived to be higher in the short- than in the long-term, the agent would prefer to hedge against low realizations of consumption in the near future by investing in long-term securities. In equilibrium, this leads to the inversion of the yield curve. Pricing time-varying consumption volatility risk is essential in order to obtain the inversion of the real curve and allows the average level and the slope of the nominal level to be priced.

Suggested Citation

  • Adriana Grasso & Filippo Natoli, 2018. "Consumption volatility risk and the inversion of the yield curve," Temi di discussione (Economic working papers) 1169, Bank of Italy, Economic Research and International Relations Area.
    • Handle: RePEc:bdi:wptemi:td_1169_18
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    References listed on IDEAS

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    Cited by:

    1. Lloyd, S. P. & Marin, E. A., 2019. "Exchange Rate Risk and Business Cycles," Cambridge Working Papers in Economics 1996, Faculty of Economics, University of Cambridge.

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    More about this item

    Keywords

    yield curve inversion; consumption volatility risk; real interest rates; macroeconomic uncertainty; habits;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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