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Bond Risk Premia in Consumption-based Models

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  • Drew D. Creal
  • Jing Cynthia Wu

Abstract

Workhorse Gaussian affine term structure models (ATSMs) attribute time-varying bond risk premia entirely to changing prices of risk, while structural models with recursive preferences credit it completely to stochastic volatility. We reconcile these competing channels by introducing a novel form of external habit into an otherwise standard model with recursive preferences. The new model has an ATSM representation with analytical bond prices making it empirically tractable. We find that time variation in bond term premia is predominantly driven by the price of risk, especially, the price of expected inflation risk that co-moves with expected inflation itself.

Suggested Citation

  • Drew D. Creal & Jing Cynthia Wu, 2016. "Bond Risk Premia in Consumption-based Models," NBER Working Papers 22183, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:22183
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    2. Martin Kliem & Alexander Meyer‐Gohde, 2022. "(Un)expected monetary policy shocks and term premia," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 37(3), pages 477-499, April.
    3. Dongho Song, 2017. "Bond Market Exposures to Macroeconomic and Monetary Policy Risks," The Review of Financial Studies, Society for Financial Studies, vol. 30(8), pages 2761-2817.
    4. Antonio Gargano & Davide Pettenuzzo & Allan Timmermann, 2019. "Bond Return Predictability: Economic Value and Links to the Macroeconomy," Management Science, INFORMS, vol. 65(2), pages 508-540, February.
    5. Leland E. Farmer & Lawrence Schmidt & Allan Timmermann, 2023. "Pockets of Predictability," Journal of Finance, American Finance Association, vol. 78(3), pages 1279-1341, June.
    6. Bu, Chunya & Rogers, John & Wu, Wenbin, 2021. "A unified measure of Fed monetary policy shocks," Journal of Monetary Economics, Elsevier, vol. 118(C), pages 331-349.
    7. Etienne Vaccaro-Grange, 2019. "Quantitative Easing and the Term Premium as a Monetary Policy Instrument," AMSE Working Papers 1932, Aix-Marseille School of Economics, France.
    8. Stachurski, John & Wilms, Ole & Zhang, Junnan, 2024. "Asset pricing with time preference shocks: Existence and uniqueness," Other publications TiSEM 29da00af-3cca-4717-aa55-a, Tilburg University, School of Economics and Management.
    9. Roman Sustek, 2021. "Yield curve and the business cycle in conventional times," Discussion Papers 2122, Centre for Macroeconomics (CFM).
    10. Huang, Dashan & Jiang, Fuwei & Li, Kunpeng & Tong, Guoshi & Zhou, Guofu, 2023. "Are bond returns predictable with real-time macro data?," Journal of Econometrics, Elsevier, vol. 237(2).
    11. Granziera, Eleonora & Sihvonen, Markus, 2024. "Bonds, currencies and expectational errors," Journal of Economic Dynamics and Control, Elsevier, vol. 158(C).
    12. Stefania D’Amico & N Aaron Pancost, 2022. "Special Repo Rates and the Cross-Section of Bond Prices: The Role of the Special Collateral Risk Premium [Pr icing the term structure with linear regressions]," Review of Finance, European Finance Association, vol. 26(1), pages 117-162.
    13. Patrick Augustin & Roméo Tédongap, 2021. "Disappointment Aversion, Term Structure, and Predictability Puzzles in Bond Markets," Management Science, INFORMS, vol. 67(10), pages 6266-6293, October.
    14. Stachurski, John & Wilms, Ole & Zhang, Junnan, 2024. "Asset pricing with time preference shocks: Existence and uniqueness," Journal of Economic Theory, Elsevier, vol. 216(C).
    15. Enoch Cheng & Clemens C. Struck, 2019. "Time-Series Momentum: A Monte-Carlo Approach," Working Papers 201906, School of Economics, University College Dublin.
    16. Zhang, Han & Fan, Xiaoyun & Guo, Bin & Zhang, Wei, 2019. "Reexamining time-varying bond risk premia in the post-financial crisis era," Journal of Economic Dynamics and Control, Elsevier, vol. 109(C).
    17. Martin M. Andreasen & Kasper Jørgensen, 2016. "Explaining Asset Prices with Low Risk Aversion and Low Intertemporal Substitution," CREATES Research Papers 2016-16, Department of Economics and Business Economics, Aarhus University.

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    More about this item

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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