Long-Run Consumption Risk and the Real Yield Curve

Abstract

This paper estimates a consumption-based, no-arbitrage model of the term structure of real interest rates. The model nests the standard long-run risk model which assumes constant market prices of risk. We find that the long-run consumption risk dominates the short-run and volatility risks and drives most of the movements of bond risk premiums. The risk premium for consumption volatility is negative, suggesting that long-term real bonds provide an effective hedge against the volatility risk in consumption growth. In contrast to the standard long-run risk model, however, we find strong evidence that the market price of long-run consumption risk is time-varying and that stochastic volatilities alone are not sufficient to account for the variations in bond risk premiums.