The term premium
18 March 2011
Main findings
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Most of the empirical research has focused on the post World War II period and the US Treasury market, and finds that the term premium is positive on average.
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The presence of excess returns on long-maturity bonds over Treasury bills contradicts the expectations hypothesis of the term structure, but the literature is inconclusive with regard to the economic rationale for the term premium.
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Most academic contributions to the term premium literature (for example, Campbell and Shiller 1991) point to a time-varying term risk premium, and an investor would have to adopt a dynamic approach towards duration exposure in order to best capture this premium.
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Historical approaches to explaining the term premium, such as the liquidity preference and the market segmentation theory, have been followed by a rich empirical literature that can be classified as influenced by financial theory (affine term structure models) or by macroeconomic theory (reduced-form models). While the finance-orientated research identifies uncertainty about the evolution of the short-term interest rate as the primary driver of the term premium, the macrofinance approach emphasises uncertainty about the macroeconomy, i.e. growth and inflation.
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The macro-finance models combine the approaches of macroeconomic literature with the noarbitrage models from financial literature and tentatively give credence to the notion that a positive term premium is compensation for risk with regard to the evolution of policy interest rates, which in turn is driven by uncertainty about underlying macroeconomic factors.