Rare Disasters and the Term Structure of Interest Rates

Abstract

This paper offers an explanation for the properties of the nominal term structure of interest rates and time-varying bond risk premia based on a model with rare consumption disaster risk. In the model, consumption is subject to large negative jumps (disasters), and these disasters are sometimes accompanied by period of high inflations. The possibility of jumps in inflation during disasters increases nominal yields and yield spread, while time-variation in disaster probability drives time-varying bond risk premia. This model also generates realistic implications for the aggregate stock market, and on the interaction between the two markets.