A Preferred-Habitat Model of the Term Structure of Interest Rates

58 Pages Posted: 22 Mar 2007 Last revised: 2 Nov 2009

See all articles by Dimitri Vayanos

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Jean-Luc Vila

Merrill Lynch & Co.

Multiple version iconThere are 3 versions of this paper

Date Written: November 1, 2009

Abstract

We model the term structure of interest rates as resulting from the interaction between investor clienteles with preferences for specific maturities and risk-averse arbitrageurs. Because arbitrageurs are risk averse, shocks to clienteles' demand for bonds affect the term structure --- and constitute an additional determinant of bond prices to current and expected future short rates. At the same time, because arbitrageurs render the term structure arbitrage-free, demand effects satisfy no-arbitrage restrictions and can be quite different from the underlying shocks. We show that the preferred-habitat view of the term structure generates a rich set of implications for bond risk premia, the effects of demand shocks and of shocks to short-rate expectations, the economic role of carry trades, and the transmission of monetary policy.

Keywords: Term structure of interest rates, preferred habitat, limited arbitrage, bond risk premia, carry trades

JEL Classification: E4, E5, G1

Suggested Citation

Vayanos, Dimitri and Vila, Jean-Luc, A Preferred-Habitat Model of the Term Structure of Interest Rates (November 1, 2009). AFA 2008 New Orleans Meetings Paper, Available at SSRN: https://ssrn.com/abstract=971439 or http://dx.doi.org/10.2139/ssrn.971439

Dimitri Vayanos (Contact Author)

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Jean-Luc Vila

Merrill Lynch & Co. ( email )

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