Term premium dynamics in an emerging market: Risk, liquidity, and behavioral factors

Abstract

This paper contributes to the fixed income research by identifying determinants of term premium in an emerging market’s treasury bond yields with particular attention on ambiguity. We use Nelson–Siegel yield curves generated from daily bond price quotes as input to construct a three-factor affine term structure model which decomposes observed yields into risk-neutral and term premium components. We also construct an ambiguity index using intraday FX return data following Brenner and Izhakian (2018). Our analyses suggest that a combination of factors representing market risk, credit risk, liquidity, ambiguity, and investor sentiments can explain majority of the variation in term premia. Explanatory power of credit risk measures are found to increase while those of volatility, ambiguity, and sentiment measures diminish with the maturity horizon. The results imply that ambiguity aversion of bond investors is a major determinant of the shape of the yield curve as it drives the premia for short end of the yield curve lower in line with the expectation of flight-to-safety behavior.