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Restrictions on Risk Prices in Dynamic Term Structure Models
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Restrictions on Risk Prices in Dynamic Term Structure Models

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  • Michael D. Bauer

Abstract

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 paper 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.

Suggested Citation

  • Michael D. Bauer, 2011. "Restrictions on Risk Prices in Dynamic Term Structure Models," Working Paper Series 2011-03, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:2011-03
    Note: ∗Previous versions of this paper were circulated under the titles “Bayesian Estimation of Dynamic Term Structure Models under Restrictions on Risk Pricing” and “Term Premia and the News.”
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    More about this item

    Keywords

    Bonds - Prices; Interest rates;

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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