Revisiting the Bond Premium Puzzle: A Robustness Approach

Abstract

We analyze a dynamic investment problem with interest rate risk and robustness. After deriving the optimal terminal wealth and investment policy, we expand our framework into a general equilibrium model, and calibrate it to data. We confirm the bond premium puzzle, i.e., in a non-robust version of our model with standard market clearing conditions neither the sign nor the magnitude of bond premiums align with empirical observations. Our proposed model with robust investors and a novel formulation of the representative agent provides a solution to both of these aspects of the bond premium puzzle. As an additional contribution, which we consider to be of interest in its own right, we develop a novel formulation of robust dynamic investment problems, and we show that a robust CRRA agent exhibits features of an Uzawa-type agent with a stochastic subjective discount rate.

Keywords: robustness, ambiguity, bond premium puzzle, stochastic subjective discount rate, dynamic asset allocation

JEL Classification: C61, G11, G12