Bond Risk Premia in Consumption-Based Models
59 Pages Posted: 25 Apr 2016 Last revised: 11 Feb 2023
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Bond Risk Premia in Consumption-Based Models
Bond Risk Premia in Consumption-Based Models
Date Written: April 2016
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.
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