Working Paper: NBER ID: w4676
Authors: David K. Backus; Stanley E. Zin
Abstract: Prices of riskfree bonds in any arbitrage-free environment are governed by a pricing kernel: given a kernel, we can compute prices of bonds of any maturity we like. We use observed prices of multi-period bonds to estimate, in a log-linear theoretical setting, the pricing kernel that gave rise to them. The high-order dynamics of our estimated kernel help to explain why first-order, one-factor models of the term structure have had difficulty reconciling the shape of the yield curve with the persistence of the short rate. We use the estimated kernel to provide a new perspective on Hansen-Jagannathan bounds, the price of risk, and the pricing of bond options and futures.
Keywords: Yield Curve; Pricing Kernel; Bond Pricing; Asset Pricing
JEL Codes: G12; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| upward slope of the yield curve (E43) | pricing kernel (D49) |
| positive autocorrelation of interest rates (E43) | pricing kernel (D49) |
| pricing kernel (D49) | bond pricing dynamics (G12) |
| pricing kernel (D49) | option pricing approaches (G13) |
| mean yield curve (E43) | mean reversion in the kernel (C22) |
| mean yield curve (E43) | mean reversion in the short rate (E43) |
| positively autocorrelated short rate (C22) | futures prices lower than forward prices (G13) |