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Implied Interest Rate Skew, Term Premiums, and the “Conundrum”

J. Benson Durham
The Journal of Fixed Income Spring 2008, 17 (4) 88-99; DOI: https://doi.org/10.3905/jfi.2008.705544
J. Benson Durham
An assistant director of the Division of Monetary Affairs and the chief of the Monetary and Financial Market Analysis Section of the Board of Governors of the Federal Reserve System in Washington, DC.
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  • For correspondence: j.benson.durham@frb.gov
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Abstract

The skew, irrespective of the mean and variance, of investors' interest rate expectations may affect required bond yields over expected short rates. Indeed, evidence suggests that the near-term skew of the option-implied distribution of short-term interest rates correlates with distant-horizon term premiums, as derived from a latent-factor affine term structure model (ATSM). Reduced-form models that include skew generally fit the data well and actually better “explain” variation in the term premium during the so-called “conundrum” than during other periods of the May 1989 to May 2007 sample. Moreover, estimates suggest that skew accounts for over half of the movement in term premiums during the “conundrum”, considerably more than any other correlate. Caveats regard the term structure of skew as well as alternative measures of the term premium. Indeed, regression analysis of movements in term premiums is plagued by specification bias on both the left- and right-hand side of the equation.

TOPICS: Statistical methods, legal/regulatory/public policy, security analysis and valuation

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The Journal of Fixed Income
Vol. 17, Issue 4
Spring 2008
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Implied Interest Rate Skew, Term Premiums, and the “Conundrum”
J. Benson Durham
The Journal of Fixed Income Mar 2008, 17 (4) 88-99; DOI: 10.3905/jfi.2008.705544

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Implied Interest Rate Skew, Term Premiums, and the “Conundrum”
J. Benson Durham
The Journal of Fixed Income Mar 2008, 17 (4) 88-99; DOI: 10.3905/jfi.2008.705544
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