Working Paper: NBER ID: w22183
Authors: Drew D. Creal; Jing Cynthia Wu
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.
Keywords: bond risk premia; consumption-based models; habit formation; inflation risk
JEL Codes: C11; E31; E43; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| time variation in bond term premia (E43) | price of risk (G19) |
| price of expected inflation risk (E31) | expected inflation (E31) |
| price of risk (G19) | term premia (G19) |
| habit formation influences (I12) | price of risk (G19) |
| time-varying price of risk (G19) | plausible term premia estimates (E43) |
| price of expected inflation risk (E31) | term premium variation (G19) |
| models without time-varying price of risk (C22) | implausible term premia estimates (C51) |