The Banking View of Bond Risk Premia
79 Pages Posted: 2 Nov 2018 Last revised: 7 Oct 2019
Date Written: October 10, 2018
Banks' balance-sheet exposure to fluctuations in interest rates strongly forecasts excess Treasury bond returns. This result is consistent with optimal risk management, a banking counterpart to the household Euler equation. In equilibrium, the bond risk premium compensates banks for bearing fluctuations in interest rates. When banks' exposure to interest rate risk increases, the price of this risk simultaneously rises. We present a collection of empirical observations supporting this view, but also discuss several challenges to this interpretation.
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