Abstract
Researchers who estimate affine term structure models often impose overidentifying restrictions (restrictions on parameters beyond those necessary for identification) for a variety of reasons. While some of those restrictions seem to have minor effects on the extracted factors and some measures of risk premia, such as the forward risk premium, they may have a large impact on other measures of risk premia that is often ignored. In this paper, we analyze how apparently innocuous overidentifying restrictions imposed on affine term structure models can lead to large differences in several measures of risk premiums.
Highlights
Understanding bond risk premia remains one of the central issues in empirical finance
The purpose of this paper is to analyze how apparently innocuous overidentifying restrictions imposed on affine term structure models (ATSM) can lead to large differences in several measures of bond risk premia
Long-term interest rates can be decomposed into expectations of average future short rates and a risk premium that investors demand for bearing long-term risk
Summary
Understanding bond risk premia remains one of the central issues in empirical finance Much of this literature uses non-arbitrage affine term structure models (ATSM) to extract risk premium components from bond prices. If the objective of the analysis is to understand bond risk premia, researchers should be very careful in not imposing overidentifying restrictions unsupported by the data even though the more parsimonious model may produce similar factors or predict better than the unrestricted model. We first analyze to what extent usual restrictions imposed on risk prices or factor dynamics imply similar estimated term and forward premiums, but may lead to large differences in excess holding returns and holding forward premiums. Using as a baseline the most general arbitrage-free Nelson and Siegel model, we evaluate to what extent the econometric rejections of the restrictions on risk prices are economically relevant (in terms of the estimated risk premia).
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