Macroeconomic Sources of Time-Varying Risk Premia in the Term Structure of Interest Rates

Abstract

ACCORDING TO INTERTEMPORAL CAPITAL ASSET pricing models (ICAPM) in finance (Merton 1983), risk premia are the prices of risk built in assets priced according to their hedging capabilities against the uncertainties related to the relevant state variables in the economy. As the uncertainties of the state variables change over time, the prices of the risk related to the state variables, and consequently the risk premia on assets in general, vary over time, too. Following the growing evidence of the failure of the expectations hypothesis and the existence of time-varying risk premia in the term structure [see Shiller (1990) for a survey on the literature], these equilibrium asset pricing models have received economists' attention as an attractive theoretical framework for modeling risk premia in the term structure of interest rates (for example, Breeden 1986; Campbell 1986, 1987). Several empirical studies attempted to test the validity of these equilibrium asset pricing models of the term structure. However, due to the failure of the theoretical ICAPM in finance to identify the important state variables, most of the studies employed empirical models that do not require a complete, explicit representation of the state variables. Consequently, those studies do not reveal any information about the importance of different macroeconomic forcing variables in the determination of time-varying risk premia. This paper investigates explicitly the linkage between time-varying risk premia in the term structure and macroeconomic state variables. In that respect, the study is