Equilibrium Term Structure Relations of Risky Assets in Incomplete Markets

This paper presents a simple theoretical model of the term structure and analyzes the relations among optimal portfolio decisions, the real term structure of asset returns, and the risks and price volatilities of assets with different terms to maturity. It is argued that specifying utility to be a non-time separable function of consumption allows for richer term structure relations then separable specifications. The model is capable to explain why term premiums vary and why the term structure may fail to be monotone. Our analysis also demonstrates that the competitive mechanism tends to undervalue short-term risks relative to long-term risks if the investors have short planning horizons