Bond Term Premium Analysis in the Presence of Multiple Regimes

Renato Guido, Kathleen D. Walsh
2004 Social Science Research Network  
This papers addresses whether observed violations in the Liquidity Preference Hypothesis (LPH) can be explained by the presence of multiple regimes in the term premia. The investigation proceeds by directly testing the LPH via a series of inequality tests which allow the moments to be conditioned on observable information using an instrumental variables approach. The apparent rejection of the LPH is then investigated by modelling the term premia over time using a simple Bayesian Markov mixture
more » ... ian Markov mixture model. The results suggest the presence of time varying term premia and multiple regimes which may explain the violations of the LPH. The Liquidity Preference Hypothesis (LPH) states that the ex ante return on government bonds is a monotonically increasing function of time to maturity. In other words, conditional on all available information, the expected holding period return on a 10 year bond should be greater than that of a 7 year bond which is greater than that of a 5 year bond and so on. The intuition underpinning the LPH is that longer maturity bonds are more risky than shorter maturity and therefore a risk premium is included in the expected holding period return (see Hicks (1946) and Kessel (1965) ). Therefore tests of the LPH amount to testing a series of inequality restrictions on the set of risk premiums. Tests of the LPH have fallen into two broad categories. Firstly, unconditional tests of the LPH have been conducted by Fama (1984) , McCulloch (1987) and Richardson,
doi:10.2139/ssrn.641445 fatcat:oxogyfanengnpgo7tn2zi4b67u