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Beauty contests and the term structure

Ellison, Martin and Tischbirek, Andreas (2018) Beauty contests and the term structure. CFM Discussion Paper Series (CFMDP2018-07). Centre For Macroeconomics, London School of Economics and Political Science, London, UK.

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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.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.centreformacroeconomics.ac.uk/Home.aspx
Additional Information: © 2018 Centre for Macroeconomics
Divisions: Centre for Macroeconomics
Subjects: H Social Sciences > HG Finance
JEL classification: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E40 - General
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Determination of Interest Rates; Term Structure of Interest Rates
G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates
Sets: Research centres and groups > Centre for Macroeconomics
Date Deposited: 10 Apr 2018 09:45
Last Modified: 20 Nov 2019 05:06
URI: http://eprints.lse.ac.uk/id/eprint/87384

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