Term Premiums in the Term Structure of Interest Rates

Abstract

THE MARKET-EQUILIBRIUM term structure of interest rates is observed as a set of macroeconomic variables. In contrast, the three main theories of the term structure are built upon differing microeconomic assumptions about the objective functions of borrowers and lenders. This paper develops a formal model of the behavior of borrowers and lenders under uncertainty in which bond investment takes place as a way of devising planned consumption streams. A new way of viewing the equilibrium term structure is proposed so that special term-structure theories emerge from particular patterns of the objective functions of participants in bond markets. The model developed and applied in this paper has several important antecedents. Bierwag and Grove [1] apply a mean-variance portfolio model to determining the term structure but follow the expectations approach in not treating term premiums. Building on their work, Roll [7, 8] introduces maturity preferences and liquidity premiums but does not derive investor demand from constrained utility maximization. Stiglitz [9] pioneers the focus on future consumption as a motive for bond holding. He redefines assets as bundles of time-state claims that are tractable in theory but lack counterparts in actual bond markets. Our work complements his by deriving an explicit expression for the term premium.