Term Structure of Interest Rates with Short-Run and Long-Run Risks

74 Pages Posted: 23 Sep 2015 Last revised: 29 Jul 2017

See all articles by Olesya V. Grishchenko

Olesya V. Grishchenko

Board of Governors of the Federal Reserve System

Zhaogang Song

Johns Hopkins University - Carey Business School

Hao Zhou

Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: July 28, 7

Abstract

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

Grishchenko, Olesya V. and Song, Zhaogang and Zhou, Hao, Term Structure of Interest Rates with Short-Run and Long-Run Risks (July 28, 7). Finance Down Under 2016 Building on the Best from the Cellars of Finance. Available at SSRN: https://ssrn.com/abstract=2663357 or http://dx.doi.org/10.2139/ssrn.2663357

Olesya V. Grishchenko (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2981 (Phone)

Zhaogang Song

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

Hao Zhou

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China
86-10-62790655 (Phone)

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