This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from longer-term interest rates, and take actions to influence those rates. The simplest model of the term structure is the expectations hypothesis, which posits that long-term interest rates are expectations of future average short-term rates. In this paper, we show that many features of the con…guration of interest rates are puzzling from the perspective of the expectations hypothesis. We review models that explain these anomalies using time-varying risk premia. Although the quest for the fundamental macroeconomic explanations of these risk premia is ongoing, in‡ation uncertainty seems to play a large role. Finally, while modern finance theory prices bonds and other assets in a single unified framework, we also consider an earlier approach based on segmented markets. Market segmentation seems important to understand the term structure of interest rates during the recent financial crisis.

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

We develop a continuous-time regime-switching model for the term structure of interest rates, in which the spot rate follows the Taylor rule, and government bonds at different maturities are priced by no-arbitrage. We allow the coefficients of the Taylor rule and the dynamics of inflation and output gap to be regime-dependent. We estimate the model using government bond yields and find that the Fed is proactive in controlling inflation in one regime but is accommodative for growth in another. Our model significantly improves the explanatory power of macroeconomic variables for government bond yields. Without the regimes, inflation and output can explain less than 50 % of the variations of contemporaneous bond yields. With the regimes, the two variables can explain more than 80 % of the variations of contemporaneous bond yields. Proactive mone-tary policies are associated with more stable inflation and output gap and therefore could have

This paper investigates the empirical performance of a new class of consumption-based, uninsurable risk models in the context of UK indexed bond market. Using closed form expressions for pricing kernels, we test the ability of three consumption-based models to …t the market prices of indexed bonds in the UK. The classical general equilibrium model performs reasonably well, in contrast to its performance in equity-pricing exercises, but is marginally outperformed by models that limit the availability of insurance. A model that prohibits all insurance appears to perform marginally better than a model that permits partial insurance. In contrast to the estimates that typically arise in equity markets, the estimated coe ¢ cient of relative risk aversion, and the resulting bond risk premia. are found to be small in the indexed bond market. The estimated price equations are used to calculate impulse responses illustrate the e¤ects of various macroeconomic shocks on real interest rates.

Level, slope, curvature of the sovereign yield curve, and fiscal behaviour

The largest credit or liquidity program created by the Federal Reserve during the financial crisis was the mortgagebacked securities (MBS) purchase program. In this paper, we examine the quantitative impact of this program on mortgage interest rate spreads. This is more difficult than frequently perceived because of simultaneous changes in prepayment risk and default risk. Our empirical results attribute a sizable portion of the decline in mortgage rates to such risks and a relatively small and uncertain portion to the program. For specifications where the existence or announcement of the program appears to have lowered spreads, we find no separate effect of the stock of MBS purchased by the Federal Reserve. JEL Codes: E52, E58, G01.

This paper investigates the risk premia of U.S. corporate and Treasury bonds. Using excess return regressions, two risk factors are derived from yield and macroeconomic data: a priced term risk factor and a priced credit risk factor explain half of the variation in one-year corporate and Treasury excess returns. The information of the term risk factor is not represented by major yield characteristics but is a hidden risk factor whereas the credit risk factor is not hidden. The term risk premium is earned primarily for exposure to inflation and the yield level and the credit risk premium is earned for an exposure to real growth and the credit spread level. The regression results are usefull for the specification of the market prices of risk in affine credit term structure models: The two-factor representation of the risk premium suggests a rank restriction on the market prices of risk and an additional pricing factor to capture the hidden property of term risk.

level, slope, curvature of the sovereign yield curve, and fiscal behaviour by António Afonso

The yield curve and the macro-economy across time and frequencies

yield curve and the macro-economy across time and frequencies