Macroeconomic Sources of Risk in the Term Structure


  • Financial support for this research was provided by the ESRC, Grant no. R000237862. We would like to express particular thanks to Peter Smith and Steffen Sorensen for their comments and help in the preparation of this paper. We would also like to thank the editor Masao Ogaki and an anonymous referee for valuable comments and suggestions.


We develop a new way of modeling time variation in term premia, based on the stochastic discount factor model of asset pricing. The joint distribution of excess U.S. bond returns of different maturity and the observable fundamental macroeconomic factors is modeled using multivariate GARCH with conditional covariances in the mean to capture the term premia. By testing the assumption of no arbitrage we derive a specification test of our model. We estimate the contribution made to the term premia at different maturities through real and nominal sources of risk. From the estimated term premia we recover the term structure of interest rates and examine how it varies through time. Finally, we examine whether the reported failures of the rational expectations hypothesis can be attributed to an omitted time-varying term premium.