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

65 Pages Posted: 13 Nov 2015

See all articles by Olesya V. Grishchenko

Olesya V. Grishchenko

Board of Governors of the Federal Reserve System

Zhaogang Song

Board of Governors of the Federal Reserve System

Hao Zhou

Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: 2015-10-07

Abstract

Bond returns are time-varying and predictable. What economic forces drive this variation? To answer this long-standing question, we propose a consumption-based model with recursive preferences, long-run risks, and inflation non-neutrality. Our model offers two important insights. First, our model matches well the post-1990 nominal upward-sloping U.S. Treasury yield curve. Second, consistent with our model's implication, variance risk premium based on the U.S. interest rate derivatives data emerges as a strong predictor for short-horizon Treasury excess returns, above and beyond the predictive power of other popular factors. In the model equilibrium, the variance risk premium is related to the short-run risks in the economy, while standard forward-rate-based factors are associated with long-run risks in the economy.

Keywords: Long-run risk, economic uncertainty, term structure of interest rates, bond risk premium, variance risk premium, predictability, interest rate derivatives

Suggested Citation

Grishchenko, Olesya V. and Song, Zhaogang and Zhou, Hao, Term Structure of Interest Rates with Short-Run and Long-Run Risks (2015-10-07). FEDS Working Paper No. 2015-95. Available at SSRN: https://ssrn.com/abstract=2684650 or http://dx.doi.org/10.17016/FEDS.2015.095

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

Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue NW
Washington, DC 20551
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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