Title: Convexity dominates risk premia in long-term forward rates
Authors: Andrea Berardi - University of Venice (Italy) [presenting]
Stephen Schaefer - London Business School (United Kingdom)
Abstract: The long end of the forward rate curve is consistently and significantly downward sloping. We show that this arises from the volatility of long-term yields and the higher convexity of long-term bonds. The downward slope of long-term forward rates therefore provides a window on the impact of volatility on the term structure. However, both volatility and the size of the slope vary significantly over time and a term structure model with stochastic volatility is necessary to account for this feature of the data. We decompose the spread into four components (the differences in expected short rates, risk premia, convexity and an "extra term") and find that it is dominated by two terms: a negative difference in the convexity effect and a positive difference in risk premia. We also show that, while the downward slope varies strongly with volatility, its average size is smaller than would be predicted if risk premia were zero, thus confirming the importance of risk premia in determining the yield curve, especially at the long end. Finally, we show that the estimates produced by our model are consistent with the deviations from the Expectations Hypothesis observed in the data, a result which contrasts with previous empirical evidence on the failure of stochastic volatility term structure models.