Discussion Paper Details

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

Author(s): Dimitri Vayanos and Jean-Luc Vila

Publication Date: November 2009

Keyword(s): Bond risk premia, Carry trades, Limited arbitrage, Preferred habitat and Term structure of interest rates

Programme Area(s): Financial Economics

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 structure---and 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.

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Bibliographic Reference

Vayanos, D and Vila, J. 2009. 'A Preferred-Habitat Model of the Term Structure of Interest Rates'. London, Centre for Economic Policy Research.