Bond Price Premiums
20 Pages Posted: 8 Dec 2012
Date Written: 2006
Nominal and real interest rates are often viewed from the perspectives of the intuitively appealing Fisher relationship and pure expectations hypothesis. These complementary relationships relate real or nominal long-term interest rates to expected future short-term interest rates and relate short- or long-term nominal interest rates to the ex ante real interest rate and the expected inflation rate. Consumption-based bond pricing theory implies that if investors are risk-averse then interest rates deviate from the Fisher relationship and the expectations hypothesis, and the deviations are described by forward premiums and inflation-risk premiums. We provide a detailed introduction to the theory, using the two Fisherian interest rate decompositions and the corresponding premiums as the organizing framework.
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