Working Paper: CEPR ID: DP7547
Authors: Dimitri Vayanos; Jean-Luc Vila
Abstract: We model the term structure of interest rates as resulting from the interaction between investor clienteles with preferences for specific maturities and risk-averse arbitrageurs. Because arbitrageurs are risk averse, shocks to clienteles' demand for bonds affect the term structure---and constitute an additional determinant of bond prices to current and expected future short rates. At the same time, because arbitrageurs render the term structure arbitrage-free, demand effects satisfy no-arbitrage restrictions and can be quite different from the underlying shocks. We show that the preferred-habitat view of the term structure generates a rich set of implications for bond risk premia, the effects of demand shocks and of shocks to short-rate expectations, the economic role of carry trades, and the transmission of monetary policy.
Keywords: Bond Risk Premia; Carry Trades; Limited Arbitrage; Preferred Habitat; Term Structure of Interest Rates
JEL Codes: E4; E5; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| demand shocks (E39) | bond prices (G12) |
| demand shocks (E39) | bond yields (G12) |
| risk-averse arbitrageurs (D81) | bond prices (G12) |
| risk-averse arbitrageurs (D81) | bond yields (G12) |
| short rate increases (E43) | bond prices (G12) |
| short rate increases (E43) | bond yields (G12) |
| short rate decreases (E43) | bond prices (G12) |
| short rate decreases (E43) | bond yields (G12) |
| slope of term structure (E43) | bond risk premia (G12) |