Riding the Yield Curve: Risk Taking Behavior in a Low Interest Rate Environment

Abstract

Investors seek to hedge against interest rate risk by taking long or short positions on bonds ofdifferent maturities. We study changes in risk taking behavior in a low interest rateenvironment by estimating a market stochastic discount factor that is non-linear and thereforeconsistent with the empirical properties of cashflow valuations identified in the literature. Weprovide evidence that non-linearities arise from hedging strategies of investors exposed tointerest rate risk. Capital losses are amplified when interest rates increase and risk averseinvestors have taken positions on instruments with longer maturity, expecting instead interestrates to revert back to their historical average.

Keywords: Interest rate increases, Discount rates, Risk premium, Financial markets, Financial instruments, Interest rate risk, non-linear stochastic discount factor, investment portfolio, termstructure model, risk aversion distribution, low interest rate environment, WP, yield curve, interest-rate, risk aversion, conditional mean, treasury security

JEL Classification: E43, C58, G11, G12, E01, G21, F16, D4, G1