The Term Structure in an Exchange Economy with Two Trees
35 Pages Posted: 23 Jan 2009 Last revised: 22 Mar 2011
Date Written: January 20, 2009
Abstract
We study the term structure of interest rates in a two-tree exchange economy. Even when one of the trees is very small, interest rates are determined differently than in a single tree economy. Rather than always being flat, the yield curve is usually upward sloping but may be downward sloping. In the latter case, the slope predicts a future increase in consumption growth rates and lower future short-term interest rates. In addition, the short and the long interest rates are driven by different variables. As in the one-tree model, the short rate depends on risk aversion; however the long rate depends on consumption growth and volatility, but not on the representative investor's risk aversion. Therefore, our results provide a resolution of the risk-free rate puzzle, and demonstrate the fragility of the one-tree model.
Keywords: Term structure, yield curve, risk-free rate puzzle, two trees, Lucas model, asset pricing
JEL Classification: E43, G12
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
The Term Structure of Interest Rates in a Pure Exchange Economy with Heterogeneous Investors
By Jiang Wang
-
Heterogeneous Expectations and Bond Markets
By Hongjun Yan and Wei Xiong
-
Heterogeneous Expectations and Bond Markets
By Hongjun Yan and Wei Xiong
-
The Price Impact and Survival of Irrational Traders
By Leonid Kogan, Stephen A. Ross, ...
-
The Price Impact and Survival of Irrational Traders
By Leonid Kogan, Stephen A. Ross, ...
-
Consensus Consumer and Intertemporal Asset Pricing with Heterogeneous Beliefs
By Elyes Jouini and Clotilde Napp
-
Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility
By Bernard Dumas, Alexander Kurshev, ...
-
Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility
By Bernard Dumas, Alexander Kurshev, ...