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The term premium

In this section, we review the theory and empirical evidence of the term premium. The term premium is the excess return that an investor obtains in equilibrium from committing to hold a long-term bond instead of a series of shorter-term bonds.

18 March 2011

Main findings

  •  Most of the empirical research has focused on the post World War II period and the US Treasury market, and finds that the term premium is positive on average.

  • The presence of excess returns on long-maturity bonds over Treasury bills contradicts the expectations hypothesis of the term structure, but the literature is inconclusive with regard to the economic rationale for the term premium.

  • Most academic contributions to the term premium literature (for example, Campbell and Shiller 1991) point to a time-varying term risk premium, and an investor would have to adopt a dynamic approach towards duration exposure in order to best capture this premium.

  • Historical approaches to explaining the term premium, such as the liquidity preference and the market segmentation theory, have been followed by a rich empirical literature that can be classified as influenced by financial theory (affine term structure models) or by macroeconomic theory (reduced-form models). While the finance-orientated research identifies uncertainty about the evolution of the short-term interest rate as the primary driver of the term premium, the macrofinance approach emphasises uncertainty about the macroeconomy, i.e. growth and inflation.

  • The macro-finance models combine the approaches of macroeconomic literature with the noarbitrage models from financial literature and tentatively give credence to the notion that a positive term premium is compensation for risk with regard to the evolution of policy interest rates, which in turn is driven by uncertainty about underlying macroeconomic factors.

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