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Term structure of interest rates: modelling the risk premium using a two horizons framework

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  • Georges Prat
  • Remzi Uctum

Abstract

This paper proposes a hybrid two-horizon risk premium model with one- and two-period maturity debts, among which the risky asset and the riskless one depend on agents’ investment horizon. A representative investor compares at each horizon the ex-ante premium offered by the market with the value they require to take a risky position, with the aim of choosing between a riskless and a risky strategy. Due to market frictions, the premium offered adjusts gradually to its required value determined by the portfolio choice theory. The required market risk premium is defined as a time-varying weighted average of the required 1- and 2-period horizon premia, where the weights represent the degree of preference of the market for each of the horizons. Our framework is more general than the standard model of the term structure of interest rates where it is assumed that the 1-period rate is the riskless rate at any time and for all agents. Setting one period equal to three months, we use 3-month ahead expected values of the US 3-month Treasury Bill rate provided by Consensus Economics surveys to estimate our 3- and 6-month horizon risk premium model using the Kalman filter methodology. We find that both 3- and 6-month maturity rates represent the riskless and the risky rates with a time-varying market preference for the former rate of about two-thirds. This result strongly rejects the standard model and shows the importance of taking into account the market preference for alternative horizons when describing risky strategies in interest rate term structure modelling.

Suggested Citation

  • Georges Prat & Remzi Uctum, 2018. "Term structure of interest rates: modelling the risk premium using a two horizons framework," EconomiX Working Papers 2018-25, University of Paris Nanterre, EconomiX.
    • Handle: RePEc:drm:wpaper:2018-25
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    More about this item

    Keywords

    interest rates; risk premium; survey data;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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