A Preferred-Habitat Model of the Term Structure of Interest Rates. Unpublished paper, London School of Economics

This paper develops a term-structure model in which investors with preferences for specific maturities trade with risk-averse arbitrageurs. Arbitrageurs integrate the markets for different maturities, incorporating information about expected short rates into bond prices. We show that bond risk premia are negatively related to short rates and positively to term-structure slope. Moreover, forward rates under-react to expected short rates, especially for long maturities, while investor demand impacts mainly long maturities. Thus, the short end of the term structure is mainly driven by short-rate expectations, while the long end by demand. Despite the presence of two distinct economic factors, the first principal component “explains ” about 90 % of movement. Our results are consistent with empirical evidence and generate novel testable implications