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

61 Pages Posted: 17 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 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: Bond risk premia, Carry trades, Limited arbitrage, Preferred habitat, Term structure of interest rates

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 2009). CEPR Discussion Paper No. DP7547, Available at SSRN: https://ssrn.com/abstract=1507541

Dimitri Vayanos (Contact Author)

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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Jean-Luc Vila

Merrill Lynch & Co. ( email )

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United States

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