Sources of Time-Varying Risk Premia in the Term Structure

This paper investigates the extent to which observable macroeconomic factors can explain the time-varying risk premia in the short-end of the term structure. The empirical model we employ is motivated by a dynamic asset pricing model with time-invariant reward-to-risk measures and time-varying risk premia. Our results indicate that two factors, based innovations in the federal funds rate and shifts in the yield curve, explain up to 65% of the temporal variation in Treasury bill returns. We also find that shifts in the yield curve factor may explain some time-variation in risk premia at the very short end of the term structure, and that the federal funds rate factor may be weakly linked to the time-varying risk premia over the post-1966 sample, when the federal funds market first began to function as a major source of bank liquidity. This latter result, however, is somewhat sensitive to the sample period