Ambiguity Aversion and the Term Structure of Interest Rates

University of St. Gallen, Department of Economics, Discussion Paper No. 2007-29

Swiss Finance Institute Research Paper No. 08-19

48 Pages Posted: 9 Aug 2007 Last revised: 5 Aug 2008

See all articles by Patrick Gagliardini

Patrick Gagliardini

USI Università della Svizzera italiana; Swiss Finance Institute

Paolo Porchia

IE Business School

Fabio Trojani

Swiss Finance Institute; University of Geneva

Multiple version iconThere are 2 versions of this paper

Date Written: July 2007

Abstract

This paper studies the term structure implications of a simple structural economy in which the representative agent displays ambiguity aversion, modeled by Multiple Priors Recursive Utility. Bond excess returns reflect a premium for ambiguity, which is observationally distinct from the risk premium of affine yield curve models. The ambiguity premium can be large even in the simplest logutility model and is non zero also for stochastic factors that have a zero risk premium. A calibrated low-dimensional two-factor economy with ambiguity is able to reproduce the deviations from the expectations hypothesis documented in the literature, without modifying in a substantial way the nonlinear mean reversion dynamics of the short interest rate. In this economy, we do not find any apparent tradeoffs between fitting the first and second moments of the yield curve and the large equity premium.

Keywords: General Equilibrium, Term Structure of Interest Rates, Ambiguity Aversion, Expectations Hypothesis, Campbell-Shiller Regression

JEL Classification: C68, G12, G13

Suggested Citation

Gagliardini, Patrick and Porchia, Paolo and Trojani, Fabio, Ambiguity Aversion and the Term Structure of Interest Rates (July 2007). University of St. Gallen, Department of Economics, Discussion Paper No. 2007-29; Swiss Finance Institute Research Paper No. 08-19. Available at SSRN: https://ssrn.com/abstract=1005082 or http://dx.doi.org/10.2139/ssrn.1005082

Patrick Gagliardini (Contact Author)

USI Università della Svizzera italiana ( email )

Via Buffi 13
Lugano, TN 6900
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Paolo Porchia

IE Business School ( email )

Serrano 99
Madrid, 28006
Spain
+34917821706 (Phone)
+34 91 745 47 62 (Fax)

HOME PAGE: http://paolo-porchia.profesores.ie.edu/

Fabio Trojani

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva ( email )

Geneva
Switzerland

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