DP7547 A Preferred-Habitat Model of the Term Structure of Interest Rates

Author(s): Dimitri Vayanos, Jean-Luc Vila
Publication Date: November 2009
Keyword(s): Bond risk premia, Carry trades, Limited arbitrage, Preferred habitat, Term structure of interest rates
JEL(s): E4, E5, G1
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7547

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.