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RFS Advance Access originally published online on November 24, 2008
Review of Financial Studies 2009 22(10):4157-4188; doi:10.1093/rfs/hhn092
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org.

Ambiguity Aversion and the Term Structure of Interest Rates

Patrick Gagliardini
University of Lugano and Swiss Finance Institute

Paolo Porchia
Swiss Institute for Banking and Finance, University of St. Gallen

Fabio Trojani
University of St. Gallen, University of Lugano, and Swiss Finance Institute

Send correspondence to Paolo Porchia, Swiss Institute for Banking and Finance, University of St. Gallen, Rosenbergstrasse 52, CH-9000 St. Gallen, Switzerland; telephone: +41-71-224-70-26; fax: +41-71-224-70-90; E-mail: paolo.porchia{at}unisg.ch.

JEL Classification: C68, G12, G13


  Abstract

This paper studies the term structure implications of a simple structural model in which the representative agent displays ambiguity aversion, modeled by Multiple Priors Recursive Utility. Bond excess returns reflect a premium for ambiguity, which is observationally distinct from the risk premium of affine yield curve models. The ambiguity premium can be large even in the simplest log-utility setting and is also nonzero for stochastic factors that have a zero risk premium. A calibrated low-dimensional two-factor model with ambiguity is able to reproduce the deviations from the expectations hypothesis documented in the literature, without modifying in a substantial way the nonlinear mean-reversion dynamics of the short interest rate. Moreover, the model does not imply any apparent trade-off between fitting the first and second moments of the yield curve.

We thank the editor (Yacine Aït-Sahalia) and two anonymous referees for many very valuable suggestions. We are also grateful to Tomas Björk, Andrea Buraschi, Anna Cieslak, Domenico Cuoco, Jerome Detemple, Damir Filipovic, Peter Gruber, Alexei Jiltsov, Abraham Lioui, Pascal Maenhout, Alessandro Sbuelz, and Andrea Vedolin for their useful comments. The authors gratefully acknowledge the financial support of the Swiss National Science Foundation (grants 12-65196/1, 101312-103781/1, 100012-105745/1, and NCCR FINRISK).


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