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Institutions and the Term Structure of Interest Rates: A Unified Lucas-Tree and Affine Pricing

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  • Heng-fu Zou

Abstract

This paper develops a unifed theoretical framework that integrates institutional quality into affine term structure models of interest rates. Building on a Lucas-tree economy with endogenous institutional capital, we derive the stochastic discount factor and show that zero-coupon bond prices admit an exponential-affine form. Using the Feynman-Kac representation, we obtain explicit Riccati equations and closed-form solutions under Vasicek- and CIR-type institutional dynamics. The analysis reveals how institutional persistence, mean reversion, and volatility affect the slope and curvature of the yield curve, generating distinct term premia across maturities. Comparative statics highlight that stronger and more stable institutions lower risk premia, while fragile or volatile institutions amplify borrowing costs. The framework bridges political economy and asset pricing, showing that institutional reforms not only promote long-run growth but also shape sovereign debt markets, financial development, and macroeconomic stability.

Suggested Citation

  • Heng-fu Zou, 2025. "Institutions and the Term Structure of Interest Rates: A Unified Lucas-Tree and Affine Pricing," CEMA Working Papers 788, China Economics and Management Academy, Central University of Finance and Economics.
    • Handle: RePEc:cuf:wpaper:788
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    1. Heng-fu Zou, 2025. "Institution-Based Asset Pricing: A Generalization of Consumption- and Production-Based Models," CEMA Working Papers 765, China Economics and Management Academy, Central University of Finance and Economics.
    2. Shleifer, Andrei & Vishny, Robert W, 1997. "A Survey of Corporate Governance," Journal of Finance, American Finance Association, vol. 52(2), pages 737-783, June.
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    5. Heng-fu Zou, 2025. "Institutional Volatility and the Equity Premium Puzzle: A Dynamic Asset Pricing Framework for OECD Economies," CEMA Working Papers 775, China Economics and Management Academy, Central University of Finance and Economics.
    6. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
    7. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
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