Restrictions on Risk Prices in Dynamic Term Structure Models

2011-03 | March 1, 2016

Restrictions on the risk-pricing in dynamic term structure models (DTSMs) tighten the link between cross-sectional and time-series variation of interest rates, and make absence of arbitrage useful for inference about expectations. This paper presents a new econometric framework for estimation of affine Gaussian DTSMs under restrictions on risk prices, which addresses the issues of a large model space and of model uncertainty using a Bayesian approach. A simulation study demonstrates the good performance of the proposed method. Data for U.S. Treasury yields calls for tight restrictions on risk pricing: only level risk is priced, and only changes in the slope affect term premia. Incorporating the restrictions changes the model-implied short-rate expectations and term premia. Interest rate persistence is higher than in a maximally-flexible model, hence expectations of future short rates are more variable–restrictions on risk prices help resolve the puzzle of implausibly stable short-rate expectations in this literature. Consistent with survey evidence and conventional macro wisdom, restricted models attribute a large share of the secular decline in long-term interest rates to expectations of future nominal short rates.

Article Citation

Bauer, Michael. 2011. “Restrictions on Risk Prices in Dynamic Term Structure Models,” Federal Reserve Bank of San Francisco Working Paper 2011-03. Available at https://doi.org/10.24148/wp2011-03

About the Author
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Michael Bauer is a senior research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco and research fellow at CEPR. Learn more about Michael Bauer