Rare Disasters and the Term Structure of Interest Rates

This paper offers an explanation for the properties of the nominal term structure of interest rates and time-varying bond risk premia based on a model with rare consumption disaster risk.  In the model, expected inflation follows a mean reverting process but is also subject to possible large (positive) shocks when consumption disasters occur.  The possibility of jumps in inflation increases nominal yields and the yield spread, while time-variation in the inflation jump probability drives time-varying bond risk premia.  Predictability regressions offer independent evidence for the model's ability to generate realistic implications for both the stock and bond markets.