The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks
45 Pages Posted: 22 Mar 2009
Date Written: January 30, 2009
The term premium on nominal long-term bonds in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data - an example of the bond premium puzzle. However, in models of endowment economies, researchers have been able to generate reasonable term premiums by assuming that investors have recursive Epstein-Zin preferences and face long-run economic risks. We show that introducing Epstein-Zin preferences into a canonical DSGE model can also produce a large and variable term premium without compromising the model's ability to fit key macroeconomic variables. Long-run real and nominal risks further improve the model's ability to fit the data with a lower level of household risk aversion.
Keywords: yield curve, term premium, bond pricing, long-run risk
JEL Classification: G12, E43
Suggested Citation: Suggested Citation