Macro-finance VARs and bond risk premia: a caveat

Taboga, Marco (2008): Macro-finance VARs and bond risk premia: a caveat.

Abstract

Around the turn of the Twentieth century, US and euro area long-term bond yields experienced a remarkable decline and remained at historically low levels even in the face of rising short-term rates (the so called "conundrum"). This unusual phenomenon has been analyzed by many researchers through the lens of macro-finance VARs and no-arbitrage term structure models. A commonly found result is that the decline in long-term rates was primarily driven by an unprecedented reduction in risk premia. I show that such result might be an artefact of the class of models employed to study the phenomenon. I propose an alternative model which suggests that, although risk premia played an important role in reducing bond yields, other two equally important forces were at play, i.e. a decline in the real natural rate of interest and a structural reduction in inflation expectations. I conclude that, after accounting for permanent shifts in the expectations about the future path of short-term rates, the dynamics of risk premia observed after the turn of the century have not been unusual if considered from an historical perspective.

• Item Type: MPRA Paper
• Language: English
• Keywords: Bond yields, forward premia, macro-finance models
• Subjects: E - Macroeconomics and Monetary Economics > E0 - General; C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates

References

Ang, A. and M. Piazzesi (2003), "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables", Journal of Monetary Economics, 50, 745-787.