Rational Expectations Model of Term Premia with Some Implications for Empirical Asset Demand Equations

Authors

  • CARL E. WALSH

    Search for more papers by this author
    • Assistant Professor, Princeton University. I would like to thank Alan Blinder and V. Vance Roley for helpful comments on an earlier version. Responsibility for errors lies with the author. This research was supported by the National Science Foundation under Grant No. SES-8408603.


ABSTRACT

This paper derives the equilibrium time series processes characterizing the prices of bonds which differ by maturity using the CAPM relationship between expected returns. The assumption of rational expectations requires that asset demand behavior, which determines bond prices in equilibrium, be based on the covariances among returns that are implied by the assumption of market clearing. This requirement imposes nonlinear restrictions on the parameters in the solution for bond prices. Some implications for the types of comparative static exercises for which it is legitimate to assume invariant demand functions are discussed, and some numerical solutions for bond prices are derived.

Ancillary