Funding Shortages, Expectations, and Forward Rate Risk Premium

Abstract

This paper estimates term risk premium and expected future spot rates embedded in Treasury forward rates to study the impact of short-term funding shortages on these quantities. Our approach is consistent with dynamic equilibrium models and avoids the arbitrage-free dynamic inconsistency problems exhibited by traditional methods. We find that short-term funding shortages in money markets affect both expectations of spot rates and forward rate risk premium for all maturity forward rates. The leverage ratio of intermediaries (primary dealers) significantly affects term risk premium but not expectations of future spot rates. Yield curve inversion has no impact on the forward rate curve’s evolution.