A Calibration of the Term Premia to the Euro Area

Credit risk-free long-term interest rates can typically be decomposed into two components: expectations of the future path of the short-term policy rate and the term premium. Changes in term premium are considered to have been an important driver behind developments in long-term bond yields in recent years. As policy rates of major central banks approached their effective lower bound in the aftermath of the global financial crisis, their ability to provide the necessary degree of monetary stimulus using conventional policy measures became very limited. In this particular context, central banks had to move beyond conventional policy instruments and instead deploy a set of unconventional tools (such as large-scale asset purchase programs and forward guidance) that were tailored to target the longer-end of the yield curve. There is a growing body of empirical evidence suggesting that these unconventional measures turned out to be effective in compressing the term premium component of interest rates. This paper, after providing a definition of the term premium and a succinct overview of different ways to measure it, presents the empirical results obtained from calibrating a Gaussian affine term structure (GATSM) based term premia model to the euro area. In addition to discussing the GATSM model’s assumptions and specifications, it also describes the calibration algorithm employed, which is based on genetic algorithms. Thereafter, it provides some insight into the time profile of the euro area term premium in the post global financial crisis (GFC) era and in particular how it has evolved after key ECB policy decisions since 2008.