Riding the Yield Curve: Risk Taking Behavior in a Low Interest Rate Environment

27 Pages Posted: 20 Apr 2020

See all articles by Ralph Chami

Ralph Chami

International Monetary Fund (IMF)

Thomas Cosimano

Independent

Céline Rochon

International Monetary Fund (IMF)

Julieta Yung

Federal Deposit Insurance Corporation

Date Written: March 2020

Abstract

Investors seek to hedge against interest rate risk by taking long or short positions on bonds ofdifferent maturities. We study changes in risk taking behavior in a low interest rateenvironment by estimating a market stochastic discount factor that is non-linear and thereforeconsistent with the empirical properties of cashflow valuations identified in the literature. Weprovide evidence that non-linearities arise from hedging strategies of investors exposed tointerest rate risk. Capital losses are amplified when interest rates increase and risk averseinvestors have taken positions on instruments with longer maturity, expecting instead interestrates to revert back to their historical average.

Keywords: Interest rate increases, Discount rates, Risk premium, Financial markets, Financial instruments, Interest rate risk, non-linear stochastic discount factor, investment portfolio, termstructure model, risk aversion distribution, low interest rate environment, WP, yield curve, interest-rate, risk aversion, conditional mean, treasury security

JEL Classification: E43, C58, G11, G12, E01, G21, F16, D4, G1

Suggested Citation

Chami, Ralph and Cosimano, Thomas and Rochon, Céline and Yung, Julieta, Riding the Yield Curve: Risk Taking Behavior in a Low Interest Rate Environment (March 2020). IMF Working Paper No. 20/53, Available at SSRN: https://ssrn.com/abstract=3579673

Ralph Chami (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States
202-623-6039 (Phone)
202-623-6068 (Fax)

Thomas Cosimano

Independent

Céline Rochon

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Julieta Yung

Federal Deposit Insurance Corporation ( email )

550 17th Street NW
Washington, DC 20006

HOME PAGE: http://https://www.fdic.gov/analysis/cfr/

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