Model Uncertainty and Term Structure Anomalies

Abstract

We construct an equilibrium term structure model that is robust to economic agent's uncertainty about the true data generating process. The low-dimensional two-factor long-run risk model captures the intuition that an ambiguity averse agent behaves pessimistically by attaching more weight to the data generating process implying a lower lifetime utility. Our calibrated model can largely match the mean interest rates and the volatility of interest rates. Importantly, the model can help resolve several challenges to standard representative-agent models such as the excess volatility puzzle, the empirical failure of the expectations hypothesis, the positive yield spread, and the predictability of bond risk premia.

Keywords: Ambiguity, bond risk premia, model uncertainty, term structure, robustness.

JEL Classification: E31, E4, G12;