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A Consumption-Based Model of the Term Structure of Interest Rates

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This paper proposed a consumption-based model that can account for many features of the nominal term structure of interest rates, such as a time-varying price of risk generated by external habit.
Abstract
This paper proposes a consumption-based model that can account for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated data on consumption, inflation, and the average level of bond yields, the model produces realistic volatility of bond yields and can explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and Fama and Bliss (1987). When Actual consumption and inflation data are fed into the model, the model is shown to account for many of the short and long-run fluctuations in the short-term interest rate and the yield spread. At the same time, the model captures the high equity premium and excess stock market volatility.

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The Rodney L. White Center for Financial Research
A Consumption-Based Model of the
Term Structure of Interest Rates
Jessica A. Wachter
27-04

A Consumption-Based Model of the Term Structure
of Interest Rates
Jessica A. Wachter
University of Pennsylvania and NBER
July 9, 2004
I thank Andrew Ang, Ravi Bansal, Michael Brandt, Geert Bekaert, John Campbell, John Cochrane,
Francisco Gomes, Vassil Konstantinov, Martin Lettau, Anthony Lynch, David Marshall, Lasse Pederson,
Andre Perold, Ken Singleton, Christopher Telmer, Jeremy Stein, Matt Richardson, Stephen Ross, Robert
Whitelaw, Yihong Xia, seminar participants at the 2004 Western Finance Association meeting in Vancouver,
the 2003 Society of Economic Dynamics meeting in Paris, and the 2001 NBER Asset Pricing meeting in
Los Angeles, the the NYU Macro lunch, the New York Federal Reserve, Washington University, and the
Wharton School. I thank Lehman Brothers for financial support.
Address: The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104;
Tel: (215) 898-7634; Email: jwachter@wharton.upenn.edu; http://finance.wharton.upenn.edu/˜ jwachter/

A Consumption-Based Model of the Term Structure
of Interest Rates
Abstract
This paper proposes a consumption-based model that can account for many features of the
nominal term structure of interest rates. The driving force behind the model is a time-varying
price of risk generated by external habit. Nominal bonds depend on past consumption growth
through habit and on expected inflation. When calibrated to data on consumption, inflation, and
the average level of bond yields, the model produces realistic volatility of bond yields and can
explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and
Fama and Bliss (1987). When actual consumption and inflation data are fed into the model, the
model is shown to account for many of the short and long-run fluctuations in the short-term interest
rate and the yield spread. At the same time, the model captures the high equity premium and
excess stock market volatility.

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Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance

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Risk Premiums in Dynamic Term Structure Models with Unspanned Macro Risks

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Term Premia and Inflation Uncertainty: Empirical Evidence from an International Panel Dataset

TL;DR: This paper constructed a panel of zero-coupon nominal government bond yields spanning ten industrialized countries and nearly two decades and computed forward rates and then used two different methods to decompose these forward rates into expected future short-term interest rates and term premiums.
References
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Journal ArticleDOI

Quadratic Term Structure Models

TL;DR: In this article, the authors identify and characterize a class of term structure models where bond yields are quadratic functions of the Markov process and characterize the properties of the bond yields and forward rates in terms of their moment conditions and characteristic functions.
Journal ArticleDOI

An Equilibrium Model of Nominal Bond Prices with Inflation-Output Correlation and Stochastic Volatility

TL;DR: In this paper, a vector autoregressive (VAR) model is used to describe the joint dynamics of consumption growth and inflation, and the mean, variance, and autocorrelation of yields are captured relatively well by the VAR-SV model.
Posted Content

The Permanent Income Hypothesis Revisited

TL;DR: The authors proposed an alternative model which is compatible with the excessive smoothness and sensitivity of consumption with respect to income, which can be interpreted as a rule-of-thumb revision, or smoothing, scheme similar to that proposed by Friedman and derived as the solution to a forward-looking intertemporal optimising problem where the rational consumer maximises a time-nonseparable utility function subject to the life-time budget constraint.
Posted Content

An equilibrium model of nominal bond prices with inflation-output correlation and stochastic volatility

TL;DR: In this paper, a vector autoregressive (VAR) model is used to describe the joint dynamics of consumption growth and inflation, and the mean, variance, and autocorrelation of yields are captured relatively well by the VAR-SV model.
Journal ArticleDOI

The term structure of real interest rates: theory and evidence from UK index-linked bonds

TL;DR: In this paper, the behavior of the default-risk-free real term structure and term premia in two general equilibrium endowment economies with complete markets but without money is studied. And the predictions are compared to data on real interest rates constructed from the UK index-linked data.
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