Restrictions on Risk Prices in Dynamic Term Structure Models

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.

Publication
Journal of Business and Economic Statistics