The Term Structure of Real Interest Rates: Theory and Evidence from UK Index-Linked Bonds

Juha Seppala
Department of Economics, University of Illinois
1206 South Sixth Street, Champaign, IL 61820, USA
tel: (217) 244-9506 fax: (217) 244-6678
email: seppala@uiuc.edu

JEL classification: E43, E44, G12.

Keywords: Term structure of interest rates, General equilibrium, Default risk, Term premia
Index-linked bonds.

September 15, 2000

Abstract

This paper studies the behavior of the default-risk-free real term structure and term premia in two general equilibrium endowment economies with complete markets but without money. In the first economy there are no frictions as in Lucas (1978) and in the second risk-sharing is limited by the risk of default as in Alvarez and Jermann (2000ab). Both models are solved numerically, calibrated to UK aggregate and household data, and the predictions are compared to data on real interest rates constructed from the UK index-linked data. While both models produce time-varying risk or term premia, only the model with limited risk-sharing can generate enough variation in the term premia to account for the rejections of expectations hypothesis.

 

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