Academic journal article Journal of Money, Credit & Banking

Macroeconomic Sources of Time-Varying Risk Premia in the Term Structure of Interest Rates

Academic journal article Journal of Money, Credit & Banking

Macroeconomic Sources of Time-Varying Risk Premia in the Term Structure of Interest Rates

Article excerpt

According to intertemporal capital asset pricing models (ICAPM) in finance (Merton 1983), risk premia are the prices of risk built in assets priced according to their hedging capabilities against the uncertainties related to the relevant state variables in the economy. As the uncertainties of the state variables change over time, the prices of the risk related to the state variables, and consequently the risk premia on assets in general, vary over time, too. Following the growing evidence of the failure of the expectations hypothesis and the existence of time-varying risk premia in the term structure [see Shiller (1990) for a survey on the literature], these equilibrium asset pricing models have received economists' attention as an attractive theoretical framework for modeling risk premia in the term structure of interest rates (for example, Breeden 1986; Campbell 1986, 1987).

Several empirical studies attempted to test the validity of these equilibrium asset pricing models of the term structure. However, due to the failure of the theoretical ICAPM in finance to identify the important state variables, most of the studies employed empirical models that do not require a complete, explicit representation of the state variables. Consequently, those studies do not reveal any information about the importance of different macroeconomic forcing variables in the determination of time-varying risk premia.

This paper investigates explicitly the linkage between time-varying risk premia in the term structure and macroeconomic state variables. In that respect, th& study is similar to that of Lauterbach (1989), who also investigates the macroeconomic sources of time-varying risk premia in the term structure within the arbitrage pricing theory (APT) framework. In contrast to the exploratory nature of Lauterbach's APT-based study, the selection of macroeconomic state variables used and the role of the state variables in the determination of time-varying risk premia in this study are carefully guided by a macroeconomic general equilibrium model of the term structure. Furthermore, a more statistically sound estimate is used for a risk measure of the state variables, compared to the simple moving average of absolute forecast errors used in Lauterbach (1989).

This study may also be viewed as an extension of an ARCH-in-mean model by Engle, Lilien, and Robins (1987). Using an autoregressive conditional heteroskedasticity (ARCH) model of conditional variance, they found a significant relationship between the conditional mean and variance of excess return, which is implied by a simple partial equilibrium asset pricing model.(1) In contrast to Engle et al. (1987), this study tries to explain time-varying risk premia in terms of time-varying conditional variances of the underlying forcing variables, based upon a general equilibrium intertemporal asset pricing model.1 Thus, this analysis can be looked upon as an attempt to trace underlying sources of ARCH-in-mean effects in the term structure documented by Engle et al. (1987).

Section 1 derives our theoretical term structure model upon which the empirical analysis is based. Section 2 describes the data, explains the econometric strategy used to estimate the model, and reports the empirical results. A brief summary and conclusion are given at the end.

1. A MODEL OF THE TERM STRUCTURE OF INTEREST RATES

In this section, a simple cash-in-advance model of the term structure is developed. The main purpose of the model is to motivate and guide empirical investigation in the next section. The model is inspired by several previous macroeconomic asset pricing models. Among others, the model can be viewed as a generalized monetary version of the real term structure model in Campbell (1986).

The model portrays an endowment economy in which there exists a large number of identical households, each of which consists of a worker-shopper pair. The pattem of trading in each period is as follows: at the beginning of each period, [Y. …

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