The 'Hairy' Premium

This paper introduces and examines an intriguing puzzle arising from the market’s persistent tendency to overestimate the trajectory of spot interest rates resulting in lucrative cumulative long-term returns for net zero investments. We introduce a new metric called the “Hairy” premium to quantify and characterize this puzzle, as well as its implications for market par- ticipants. Borrowers seeking floating-rate loans and investors seeking fixed-rate assets both benefit from this premium as an abnormal return. Since the 1990s, the average 10-year “Hairy” premium in the US has been 2.8%, ranging between a maximum of 4.7% and a minimum of 0.7% per annum, and has thus consistently remained above zero, indicating an asymmetric risk-reward ratio. While the “Hairy” premium is among the highest in the US, it is not a uniquely US phenomenon or confined to recent periods, as it is observed globally and spanning over a century as far back as our data allows. About 82% is driven by a single factor common to all G11 economies. We find that the “Hairy” premium is positively related to recessions and inflation expectations, except in rare instances of monetary tightening. This phenomena is also observable in surveys of professional forecasters, suggesting that the premium predominantly reflects professional investor expectations, preferences, and risk aversion preceding regulatory or financial intermediary frictions as well as subjective consumer inflation expectations