Restrictions on Risk Prices in Dynamic Term Structure Models. Issue 2 (3rd April 2018)

• Record Type: Journal Article
• Authors: Bauer, Michael D.
• Is Part Of: Journal of business & economic statistics. Volume 36:Issue 2(2018)
• Page Start: 196
• Page End: 211
• Publication Date: 2018-04-03
• Subjects: Markov-chain Monte Carlo -- Model selection -- No-arbitrage -- Prices of risk -- Term premium; Economics -- Statistical methods -- Periodicals; Commercial statistics -- Periodicals; Économie politique -- Méthodes statistiques -- Périodiques; Statistique commerciale -- Périodiques; 330.015195
• DOI: 10.1080/07350015.2016.1164707
• Languages: English
• ISSNs: 0735-0015

Abstract

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 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.