Supply and Demand and the Term Structure of Interest Rates
49 Pages Posted: 20 Nov 2023 Last revised: 8 Feb 2025
Date Written: November 2023
Abstract
We survey the growing literature emphasizing the role that supply-and-demand forces play in shaping the term structure of interest rates. Our starting point is the Vayanos and Vila (2009, 2021) model of the term structure of default-free bond yields, which we present in both discrete and continuous time. The key friction in the model is that the bond market is partially segmented from other financial markets: the prices of short-rate and bond supply risk are set by specialized bond arbitrageurs who must absorb shocks to the supply and demand for bonds from other “preferred-habitat” agents. We discuss extensions of this model in the context of default-free bonds and other asset classes.
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