DP12762 | Beauty Contests and the Term Structure

Publication Date

02/28/2018

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Abstract

A novel decomposition highlights the scope for information to influence the term structure of interest rates. Based on the law of total covariance, we show that real term premia in macroeconomic models contain a component that depends on covariances of realised stochastic discount factors and a component that depends on covariances of expectations of those stochastic discount factors. The impact of different informational assumptions can then be identified by looking at their effect on the second, expectational, component. If agents have full information about technology in a simple macro-finance model then the conditional covariance of expectations is low, which contributes to the real term premia implied by the model being at least an order of magnitude too small, a result that is unchanged if some components of technology are unobservable or observed with noise. To generate realistic term premia, we draw on the beauty contest literature by differentiating between private and public information and introducing the possibility of strategic complementarities in the formation of expectations. A quantitative version of the model is found to explain a significant proportion of observed term premia when estimated using data on expectations of productivity growth from the Survey of Professional Forecasters.