Risk Aversion, Intertemporal Substitution, and the Term Structure of Interest Rates

54 Pages Posted: 14 Nov 2009

See all articles by René Garcia

René Garcia

Université de Montréal - CIREQ - Département de sciences économiques; University of Montreal

Richard Luger

Emory University - Department of Economics

Date Written: May 1, 2009

Abstract

We build and estimate an equilibrium model of the term structure of interest rates based on a recursive utility specification. We contrast it with an arbitrage-free model, where prices of risk are estimated freely without preference constraints. In both models, nominal bond yields are affine functions of macroeconomic state variables. The equilibrium model accounts for the tent-shaped pattern and magnitude of coefficients from predictive regressions of excess bond returns on forward rates and the hump-shaped pattern in the term structure of volatilities, while the reduced-form no-arbitrage model does not account for these important features of the yield curve.

Keywords: Recursive utility, Yield curve, Affine macro-finance model, Bond risk premium, Expectations puzzle

JEL Classification: E43, E44, G12

Suggested Citation

Garcia, René and Luger, Richard, Risk Aversion, Intertemporal Substitution, and the Term Structure of Interest Rates (May 1, 2009). CIRANO - Scientific Publications 2009s-20, Available at SSRN: https://ssrn.com/abstract=1504072 or http://dx.doi.org/10.2139/ssrn.1504072

René Garcia (Contact Author)

Université de Montréal - CIREQ - Département de sciences économiques ( email )

C.P. 6128, succursale Centre-Ville
3150, rue Jean-Brillant, bureau C-6027
Montreal, Quebec H3C 3J7
Canada
514-985-4014 (Phone)

University of Montreal ( email )

United States

Richard Luger

Emory University - Department of Economics ( email )

1602 Fishburne Drive
Atlanta, GA 30322
United States
404-727-0328 (Phone)
404-727-4639 (Fax)

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