Restrictions on Risk Prices in Dynamic Term Structure Models
Restrictions on the risk-pricing in dynamic term structure models (DTSMs) tighten the link between cross-sectional and time-series variation of interest rates, and make absence of arbitrage useful for inference about expectations. This article presents a new econometric framework for estimation of a...
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Published in | Journal of business & economic statistics Vol. 36; no. 2; pp. 196 - 211 |
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Main Author | |
Format | Journal Article |
Language | English |
Published |
Alexandria
American Statistical Association
01.04.2018
Taylor & Francis Ltd |
Subjects | |
Online Access | Get full text |
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Summary: | Restrictions on the risk-pricing in dynamic term structure models (DTSMs) tighten the link between cross-sectional and time-series variation of interest rates, and make absence of arbitrage useful for inference about expectations. This article presents a new econometric framework for estimation of affine Gaussian DTSMs under restrictions on risk prices, which addresses the issues of a large model space and of model uncertainty using a Bayesian approach. A simulation study demonstrates the good performance of the proposed method. Data for U.S. Treasury yields calls for tight restrictions on risk pricing: only level risk is priced, and only changes in the slope affect term premia. Incorporating the restrictions changes the model-implied short-rate expectations and term premia. Interest rate persistence is higher than in a maximally flexible model, hence expectations of future short rates are more variable—restrictions on risk prices help resolve the puzzle of implausibly stable short-rate expectations in this literature. Consistent with survey evidence and conventional macro wisdom, restricted models attribute a large share of the secular decline in long-term interest rates to expectations of future nominal short rates. Supplementary materials for this article are available online. |
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ISSN: | 0735-0015 1537-2707 |
DOI: | 10.1080/07350015.2016.1164707 |