Implied Interest Rate Skew, Term Premiums, and the Conundrum

Posted: 22 May 2019

Date Written: October 2007

Abstract

The skew, irrespective of the mean and variance, of investors' interest rate expectations may affect required bond yields over expected short rates. Indeed, evidence suggests that the near-term skew of the option-implied distribution of expected short-term interest rates correlates with distant-horizon term premiums, as derived from a latent-factor affine term structure model (ATSM). Reduced-form models that include skew generally fit the data well and actually better explain variation in the term premium during the so-called conundrum than during other periods of the May 1989 to May 2006 sample. Moreover, estimates suggest that skew accounts for over half of the movement in term premiums during the conundrum, considerably more than any other correlate. Caveats regard the term structure of skew as well as alternative measures of the term premium. Indeed, regression analysis of movements in term premiums is plagued by specification bias on both the left- and right-hand-side of the equation.

Keywords: Implied skew, term premiums, affine term structure model, conundrum

JEL Classification: G0

Suggested Citation

Durham, J. Benson, Implied Interest Rate Skew, Term Premiums, and the Conundrum (October 2007). FEDS Working Paper No. 2007-55. Available at SSRN: https://ssrn.com/abstract=1048841 or http://dx.doi.org/10.2139/ssrn.1048841

J. Benson Durham (Contact Author)

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States
12128103082 (Phone)

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