Restrictions on Risk Prices in Dynamic Term Structure Models

35 Pages Posted: 19 Mar 2012 Last revised: 26 Jan 2017

Multiple version iconThere are 2 versions of this paper

Date Written: March 3, 2016


Restrictions on the risk-pricing in dynamic term structure models (DTSMs) tighten the link between cross-sectional and time-series variation of interest rates, and make absence of arbitrage useful for inference about expectations. This paper presents a new econometric framework for estimation of affine Gaussian DTSMs under restrictions on risk prices, which addresses the issues of a large model space and of model uncertainty using a Bayesian approach. A simulation study demonstrates the good performance of the proposed method. Data for U.S. Treasury yields calls for tight restrictions on risk pricing: only level risk is priced, and only changes in the slope affect term premia. Incorporating the restrictions changes the model-implied short-rate expectations and term premia. Interest rate persistence is higher than in a maximally-flexible model, hence expectations of future short rates are more variable--restrictions on risk prices help resolve the puzzle of implausibly stable short-rate expectations in this literature. Consistent with survey evidence and conventional macro wisdom, restricted models attribute a large share of the secular decline in long-term interest rates to expectations of future nominal short rates.

Keywords: no-arbitrage, prices of risk, term premium, Markov-chain Monte Carlo, model selection

JEL Classification: C52, E43, G12

Suggested Citation

Bauer, Michael, Restrictions on Risk Prices in Dynamic Term Structure Models (March 3, 2016). Journal of Business and Economic Statistics, Forthcoming, Available at SSRN: or

Michael Bauer (Contact Author)

Universit├Ąt Hamburg ( email )

Von-Melle-Park 5
Hamburg, 20146


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