A consumption-based model of the term structure of interest rates☆

Abstract

This paper proposes a consumption-based model that accounts for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated to data on consumption, inflation, and the aggregate market, the model produces realistic means and volatilities of bond yields and accounts for the expectations puzzle. The model also captures the high equity premium and excess stock market volatility. Disciplines Finance | Finance and Financial ManagementThis journal article is available at ScholarlyCommonsAbstract This paper proposes a consumption-based model that can account for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated to data on consumption, inflation, and the average level of bond yields, the model produces realistic volatility of bond yields and can explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and Fama and Bliss (1987). When actual consumption and inflation data are fed into the model, the model is shown to account for many of the short and long-run fluctuations in the short-term interest rate and the yield spread. At the same time, the model captures the high equity premium and excess stock market volatility.

Solving an asset pricing model with hybrid internal and external habits, and autocorrelated Gaussian shocks

“…32 In the original Campbell and Cochrane model the standard deviation of bond returns was zero. Wachter (2006) allows for more realistic fluctuations in bond returns.…”

Expectations Hypothesis and Term Structure of Interest Rates: An Evidence from Emerging Market

“…Kotomin (2011) found that the year-end and the quarter-end preferences are not the only reason for rejection of expectations hypothesis, but factors like time variant risk premium, monetary policy reaction and irrationality of investors have also contributed to the anomalies. The consumption-based models of Wachter (2006), Bach andMøller (2011), Engsted et al (2010), Campbell and Cochrane (1999), Harvey (1988), Hyde and Sherif (2010) and Madureira (2007) explain the behavior of term structure. Wachter (2006) documented that the basic premise that determine the nominal term structures of interest rates is the random walk behavior of asset price risk formulated by the external habitat.…”

“…The consumption-based models of Wachter (2006), Bach andMøller (2011), Engsted et al (2010), Campbell and Cochrane (1999), Harvey (1988), Hyde and Sherif (2010) and Madureira (2007) explain the behavior of term structure. Wachter (2006) documented that the basic premise that determine the nominal term structures of interest rates is the random walk behavior of asset price risk formulated by the external habitat. Together with habitat the expected inflation acts as a medium through which nominal bonds relate to past consumption growth.…”

On the predictive power of the surplus consumption ratio

“…They showed that low surplus consumption ratio, or equivalently low consumption to habit stock ratio, predicts high expected returns in the next period. Wachter (2006) extended the model to develop a consumption-based term structure model. However, with the exception of Li (2005), the literature has not investigated the ability of this consumption indicator (i) to predict excess returns at long horizons and (ii) to explain the variation in average returns in cross section.…”