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Consumption volatility risk and the inversion of the yield curve

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  • Grasso, Adriana
  • Natoli, Filippo

Abstract

We propose a consumption-based model that allows for an inverted term structure of real and nominal risk-free rates. In our framework the agent is subject to time-varying macroeconomic risk and interest rates at all maturities depend on her risk perception which shape saving propensities over time. In bad times, when risk is perceived to be higher in the short- than the long-term, the agent would prefer to hedge against low realizations of consumption in the near future by investing in long-term securities. This determines, in equilibrium, the inversion of the yield curve. Pricing time-varying consumption volatility risk is essential for obtaining the inversion of the real curve and allows to price the average level and slope of the nominal one. JEL Classification: G12

Suggested Citation

  • Grasso, Adriana & Natoli, Filippo, 2018. "Consumption volatility risk and the inversion of the yield curve," Working Paper Series 2141, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20182141
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    Cited by:

    1. Lloyd, S. P. & Marin, E. A., 2019. "Exchange Rate Risk and Business Cycles," Cambridge Working Papers in Economics 1996, Faculty of Economics, University of Cambridge.

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    More about this item

    Keywords

    habits; inverted yield curve; real rates; uncertainty; volatility risk;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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