The Government Risk Premium Puzzle

62 Pages Posted: 4 Mar 2019 Last revised: 11 Oct 2019

See all articles by Zhengyang Jiang

Zhengyang Jiang

Kellogg School of Management - Department of Finance

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); New York University Stern School of Business, Department of Finance

Mindy Z. Xiaolan

University of Texas, Austin - Department of Finance

Date Written: October 10, 2019

Abstract

The market value of outstanding government debt reflects the expected present discounted value of current and future primary surpluses. When the discount rate is consistent with the term structure of interest rates and equity prices and government spending growth dynamics are estimated from the data, a government risk premium puzzle emerges. Since tax revenues are pro-cyclical while government spending is counter-cyclical, the tax revenue claim has a higher risk premium and a lower value than the spending claim. This makes the value of the surplus claim negative, and implies that the U.S. government should be a creditor rather than a debtor. We resolve this puzzle by postulating a small but persistent component in expected spending growth, and infer it from the market value of the outstanding government bond portfolio. This component offsets the pro-cyclical movements in current surpluses, reducing its risk and increasing its value. The resulting model is used to study the optimal maturity structure of government debt, and to quantify deviations of the observed portfolio from the optimal one.

Keywords: government debt maturity, fiscal policy, term structure, interest rate risk

JEL Classification: E44, E62, G12, H6

Suggested Citation

Jiang, Zhengyang and Lustig, Hanno N. and Van Nieuwerburgh, Stijn and Xiaolan, Mindy Z., The Government Risk Premium Puzzle (October 10, 2019). Available at SSRN: https://ssrn.com/abstract=3333517 or http://dx.doi.org/10.2139/ssrn.3333517

Zhengyang Jiang

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

HOME PAGE: http://https://sites.google.com/site/jayzedwye/

Hanno N. Lustig

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Stijn Van Nieuwerburgh (Contact Author)

Columbia University Graduate School of Business ( email )

3022 Broadway
Uris Hall 809
New York, NY New York 10027
United States

HOME PAGE: http://https://www0.gsb.columbia.edu/faculty/svannieuwerburgh/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

New York University Stern School of Business, Department of Finance ( email )

44 West 4th Street
Suite 9-190
New York, NY 10012-1126
United States

Mindy Z. Xiaolan

University of Texas, Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States

HOME PAGE: http://sites.google.com/view/mindyxiaolan

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