Bond Risk Premia in Consumption-based Models

Drew D. Creal, Jing Cynthia Wu

NBER Working Paper No. 22183
Issued in April 2016
NBER Program(s):   AP   EFG   ME 

Workhorse Gaussian affine term structure models (ATSMs) attribute time-varying bond risk premia entirely to changing prices of risk, while structural models with recursive preferences credit it completely to stochastic volatility. We reconcile these competing channels by introducing a novel form of external habit into an otherwise standard model with recursive preferences. The new model has an ATSM representation with analytical bond prices making it empirically tractable. We find that time variation in bond term premia is predominantly driven by the price of risk, especially, the price of expected inflation risk that co-moves with expected inflation itself.