Term Structure of Interest Rates with Short-Run and Long-Run Risks
74 Pages Posted: 23 Sep 2015 Last revised: 29 Jul 2017
Date Written: July 28, 7
Interest rate variance risk premium (IRVRP), the difference between implied and realized variances of interest rates, emerges as a strong predictor of Treasury bond returns of maturities ranging between one and ten years for return horizons up to six months. IRVRP is not subsumed by other predictors such as forward rate spread or equity variance risk premium. These results are robust in a number of dimensions. We rationalize our findings within a consumption-based model with long-run risk, economic uncertainty, and inflation non-neutrality. In the model interest rate variance risk premium is related to short-run risk only, while standard forward-rate-based factors are associated with both short-run and long-run risks in the economy. Our model qualitatively replicates the predictability pattern of IRVRP for bond returns.
Keywords: Long-run risk, economic uncertainty, variance risk premium, bond return predictability, term structure of interest rates, interest rate derivatives
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation