A Preferred-Habitat Model of the Term Structure of Interest Rates

Abstract

We model the term structure of interest rates as resulting from the interaction between investor clienteles with preferences for specific maturities and risk-averse arbitrageurs. Because arbitrageurs are risk averse, shocks to clienteles' demand for bonds affect the term structureand constitute an additional determinant of bond prices to current and expected future short rates. At the same time, because arbitrageurs render the term structure arbitrage-free, demand effects satisfy no-arbitrage restrictions and can be quite different from the underlying shocks. We show that the preferred-habitat view of the term structure generates a rich set of implications for bond risk premia, the effects of demand shocks and of shocks to short-rate expectations, the economic role of carry trades, and the transmission of monetary policy.

The Federal Reserve's Large‐scale Asset Purchase Programmes: Rationale and Effects

“…The position that longer term yields depend in part on the relative quantities outstanding of longer term assets in the hands of the private sector (including commercial banks) was the subject of a substantial literature in the 1950s and the 1960s (Culbertson, 1957; Modigliani and Sutch, 1966; Wallace, 1967; and the references discussed in ). Recently, Vayanos and Vila (2009) have offered more rigorous foundations for this approach within a term‐structure model with two types of investors. The preferred‐habitat investors in this framework are disposed to purchasing securities of certain maturities, while arbitrageurs can profit by trading across maturities but risk aversion prevents these agents from taking complete advantage of profit opportunities 16…”

“…The Vayanos and Vila (2009) preferred‐habitat framework referred to above, in addition to featuring local supply effects, also implies a direct relationship between the term premium and the average duration risk faced by investors, in particular by the arbitrageurs 17 . To the extent that LSAP‐style measures remove duration risk from the market by withdrawing a portion of long‐term securities, the risk premium built into the price of such assets should decline.…”

“…In outlining the effect of LSAPs on term premiums, Kohn (2009) and Yellen (2011) appeal to the preferred‐habitat literature. This literature, developed at an early stage by Tobin (1961, 1963) and Modigliani and Sutch (1966, 1967), has received a modern formalisation in the work by Vayanos and Vila (2009).…”

The Macroeconomic Effects of Large‐scale Asset Purchase Programmes

“…In particular, we follow Andrés et al. (2004, henceforth ALSN) and assume that investors have heterogeneous preferences for assets of different maturities (a ‘preferred habitat’ motive, similar to Vayanos and Vila, 2009). We do not model the details of why assets of different maturities are imperfect substitutes.…”

Derivatives pricing when supply and demand matter: Evidence from the term structure of VIX futures

“…The fixed income literature includes analogous research examining the impact of bond supply on the term structure. Vayanos and Vila () and Kaminska, Vayanos, and Zinna () examine “Preferred Habitat” models of US Treasury securities. In these papers, the term structure is determined by the interaction of investor clienteles with preferences for specific maturities of bonds and risk‐averse arbitrageurs who absorb their demands.…”