A Consumption-Based Model of the Term Structure of Interest Rates

Rodney L. White Center for Financial Research Working Paper No. 27-04

52 Pages Posted: 11 Sep 2004  

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Date Written: July 9, 2004

Abstract

This paper proposes a consumption-based model that can account for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated data on consumption, inflation, and the average level of bond yields, the model produces realistic volatility of bond yields and can explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and Fama and Bliss (1987). When Actual consumption and inflation data are fed into the model, the model is shown to account for many of the short and long-run fluctuations in the short-term interest rate and the yield spread. At the same time, the model captures the high equity premium and excess stock market volatility.

Suggested Citation

Wachter, Jessica A., A Consumption-Based Model of the Term Structure of Interest Rates (July 9, 2004). Rodney L. White Center for Financial Research Working Paper No. 27-04. Available at SSRN: https://ssrn.com/abstract=587952 or http://dx.doi.org/10.2139/ssrn.587952

Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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