Explaining The Term Structure Of Interest Rates: A Panel Data Approach

This paper demonstrates that a time-varying risk premium can account for the rejection of the expectations theory of the term structure of interest rates. Rather than model risks directly, in terms of observables, we instead exploit an implication of the capital asset pricing model concerning how risk premia for a given maturity structure will vary through time in a related manner across different types of assets. We use a panel data set of returns on Eurocurrency deposits and employ cross-section/time-series methods to account for related movements in risk premia across assets that differ by currency denomination. We find that our ability to explain the term structure of interest rates is greatly improved by allowing for these unobserved but related movements in risk premia. In addition, the methodology developed in this paper can be used to model time-varying risk premia when studying other types of present-value relationships in financial markets.