State Uncertainty Aversion and the Term Structure of Interest Rates

Abstract

This paper proposes a new explanation for the empirical finding that yields on risk-free bonds are increasing with their maturity (the term premium). The key assumption is that investors not only dislike risk, but also dislike uncertainty about the current trend growth rate of the economy. In the proposed model, investors observe consumption growth rates and use these observations to estimate the current level of a mean reverting trend growth rate. At a given point in time, uncertainty is given by the variance of the estimate. Disliking uncertainty, investors bias their estimate of the current trend downwards. On average this lowers short term interest rates relative to long run interest rates. The model can account quantitatively for the observed term premium in the US data and correctly predicts the flattening of the real yield curve since the early nineties.