Business Intelligence

Uncertainty Aversion And The Term Structure Of Interest Rates

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Executive Summary

This paper proposes a novel explanation for the empirical finding that yields on risk-free bonds are increasing with their maturity (the term premium). The key ingredient in the explanation is that investors not only dislike risk, but also dislike uncertainty about the current trend growth rate of the economy. The model setup is one where investors observe consumption growth rates and use these observations to estimate the current level of a mean reverting trend growth rate. At a given point in time, uncertainty about the state is given by the variance of the estimate. Disliking uncertainty, investors bias their estimate of the current trend downwards.

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