WP/20/53

Riding the Yield Curve: Risk Taking Behavior in a

Low Interest Rate Environment

by Ralph Chami, Thomas F. Cosimano, Céline Rochon, Julieta Yung

IMF Working Papers describe research in progress by the author(s) and are published to
elicit comments and to encourage debate. The views expressed in IMF Working Papers are
those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board,
or IMF management.
© 2020 International Monetary Fund WP/20/53

IMF Working Paper

Institute for Capacity Development

Riding the Yield Curve: Risk Taking Behavior in a

Low Interest Rate Environment *

Prepared by Ralph Chami, Thomas F. Cosimano, Céline Rochon, Julieta Yung

Authorized for distribution by Ralph Chami and Norbert Funke

March 2020

IMF Working Papers describe research in progress by the author(s) and are published
to elicit comments and to encourage debate. The views expressed in IMF Working
Papers are those of the author(s) and do not necessarily represent the views of the IMF, its
Executive Board, or IMF management.

Abstract

Investors seek to hedge against interest rate risk by taking long or short positions on bonds of
different maturities. We study changes in risk taking behavior in a low interest rate
environment by estimating a market stochastic discount factor that is non-linear and therefore
consistent with the empirical properties of cashflow valuations identified in the literature. We
provide evidence that non-linearities arise from hedging strategies of investors exposed to
interest rate risk. Capital losses are amplified when interest rates increase and risk averse
investors have taken positions on instruments with longer maturity, expecting instead interest
rates to revert back to their historical average.

JEL Classification Numbers: E43; C58; G11; G12

Keywords: Interest rate risk; non-linear stochastic discount factor; investment portfolio; term
structure model; risk aversion distribution; low interest rate environment
Author’s E-Mail Address: [email protected], [email protected], [email protected],
[email protected]

∗
The authors would like to thank participants at the “New Normality, New Risks” 2020 Conference hosted by
Institut Louis Bachelier, Paris; the 4th International Workshop on Financial Markets and Nonlinear Dynamics;
the 15th Annual Conference of Macroeconomists from Liberal Arts Colleges; the 10th RCEA Macro-Money-
Finance Conference; and the Bates College Casey Lecture Fund in Economics Seminar Series for helpful
comments and suggestions. The paper also benefitted from comments from IMF staff in RES and Ricardo Sousa's
insightful discussion.
 Contents

I. Introduction ……………………………………………………………………… 1

II. Non-linearities in Bond Market Valuations ……………………………………… 4

A. Prices of Risk in a Term Structure Model ……………………………………. 4

B. The Expected Stochastic Discount Factor ……………………………………. 8

C. Application: The November 2016 Change in Yields …………………………. 9

III. Investors’ Risk Aversion and Portfolio Positions ………………………………... 11

A. Portfolio Rules ………………………………………………………………... 11

B. Hedging Strategies in a Low Interest Rate Environment ……………………... 16

IV. Conclusion ……………………………………………………………………….. 20

References ……………………………………………………………………………… 21
 I. Introduction

Financial market participants hedge against interest rate risk by taking long or short posi-
tions on bonds of different maturities, i.e. the “riding the yield curve” strategy. If investors
anticipate an increase in interest rates (it ), standard macroeconomic theory would suggest a
decline in expected future cashflows, the “stochastic discount factor” or SDF,

1
= ↓ Et [SDFt+1 ]. (1)
1 + ↑it

This theoretical relationship follows from an SDF that is positive and monotonically decreas-
ing in economic activity, an argument that holds under the assumption of complete markets
(Dybvig, 1988), and therefore provides limited opportunities to hedge against interest rate
fluctuations.1 There is substantial evidence, however, that the expected SDF varies over
time and is non-monotonic.2 Intuitively, this means that if investors anticipate a one per-
centage point increase in interest rates, their portfolio rebalancing strategy would depend on
whether interest rates were lower than average (and therefore reverting back to the mean),
or higher than average (and therefore moving even further away from the mean).

In this paper, we derive and empirically estimate a non-monotonic SDF and we identify
investors’ hedging strategy against interest rate risk as the source of non-linearities in their
cashflow valuation process. This framework allows for investors to (i) respond to movements
along the entire yield curve – not just the short rate, (ii) evaluate movements in interest
rates in relation to their historical averages, and (iii) develop hedging strategies given their
relative risk aversion. To illustrate the importance of non-linearities, we consider investors
in a low interest rate environment as they optimize their portfolios to account for interest
rate fluctuations.

In order to study risk-taking behavior in a low interest rate environment, we derive the mar-
ket’s stochastic discount factor from a canonical term structure model under the assumption
of no arbitrage, in which the U.S. yield curve is described by observable interest-rate risk
factors that capture cross-sectional variation in interest rates as in Joslin et al. (2011) and
Adrian et al. (2013). The model is parsimonious and econometrically tractable, yet successful
1
In particular, popular models used by Central Banks to understand the effects of monetary policy on the
economy such as FRB/US (Brayton et al., 2014) at https://www.federalreserve.gov/econresdata/frbus/us-
models-about.htm and Euro (Smets and Wouters, 2003, 2007; Christoffel et al., 2008), have this limitation
in terms of reflecting financial market participants’ attitudes towards risk.
2
See Campbell (2014) for a discussion of the contributions of Eugene Fama, Lars Peter Hansen, and
Robert Shiller to this line of research, which is the basis for their 2013 Nobel Memorial Prize in Economic
Sciences.

1
at explaining interest rate movements and inferring the market prices of risk that describe
how interest-rate risk factors relate to the investor’s SDF.

First, we show that the probability density function of the SDF is log-normal, thus introduc-
ing time-variation and non-linearity with respect to the risk factors, consistent with empirical
evidence in the macro-finance literature.3 Following Chami et al. (2017) and Cosimano and
Ma (2018), we derive the conditional expected SDF in the bond market, relative to each one
of the interest-rate risk factors moving, while holding all else constant. We use the move-
ments in the bond market following the 2016 U.S. presidential elections to illustrate how as
the interest-rate risk factors change, expected cashflow valuations increase when the yield
curve movements occur to the left of the conditional mean of the expected SDF, yet decrease
when they are to the right. This feature is an important distinction that arises from the
Gaussian properties of the probability density function of the SDF.

Second, we provide evidence that non-linearity in the SDF arises naturally as investors choose
their portfolio positions to hedge against interest rate risk, even under standard constant
relative risk averse preferences. Following the optimization problem in Sangvinatsos and
Wachter (2005), we find the optimal portfolio rule for an investor that takes as given the
linear relation between the expected excess return on bonds and the interest-rate risk factors.
These portfolio rules are also linear in the Sharpe ratio of U.S. Treasury securities, a leverage
constraint, and the risk factors, and are derived for an investor with a constant relative risk
aversion utility for terminal wealth.4 Hedging strategies arise from investors’ conditional
expectations of future interest rate movements. Investors go long on long-term securities
when yields are above their historical average and vice versa. Given these hedging positions,
investors suffer a capital loss when the future yields move away from their long-term mean.

Our framework allows us to study portfolio choices for investors with different levels of risk
aversion and examine both the direct and indirect effects of interest rate fluctuations. By
multiplying investors’ portfolio rules (which state the percentage of wealth invested in each
security) by their respective wealth levels, we obtain the demand for all the maturities of U.S.
Treasury securities. We equate total demand to the total supply of government securities
made available to the market, following Wang (1994)’s model of stock market volume and
Vayanos and Vila (2009)’s model of preferred habitat in the market for Treasury securities,
3
For example, Cochrane (2011) found substantial time variation in the discount rate or expected SDF
across many financial assets including the expected excess return on longer-term bonds.
4
If the investors also have distinct investment horizon, then the hedging demand strategy will depend on
different mean and variance-covariances according to the investor’s horizon.

2
which derives the investor’s preferred habitat based on the absolute risk aversion of the
investor.

The expected SDF for the market is an envelope of Gaussian distributions, since the equi-
librium excess return on Treasury securities is an affine function of the interest-rate risk
factors, which are normally distributed. As a result, we find that in a low interest rate envi-
ronment, the market equilibrium is such that the more risk averse investors hold portfolios
with longer duration relative to less risk averse investors, and therefore experience larger
capital losses when the estimated level of the yield curve increases. For more risk averse
investors, this change leads to a decrease in their valuation of cashflows; whereas less risk
averse investors experience an increase in the valuation of their cash flows, and they take
the opposite position on longer-term securities. This behavior leads to a second indirect
effect of interest rate movements through changes in the distribution of the absolute risk
aversion of the investors. Investors with capital gains have higher wealth in the future and
lower absolute risk aversion, since wealthier individuals are more willing to take on risk.
On the other hand, investors who suffer a capital loss have higher absolute risk aversion,
making them even more conservative in their portfolio positions. Thus, an increase in the
estimated level of the yield curve in a low interest rate environment changes the distribution
of investors’ absolute risk aversion, which increases the investors aversion to risk relative to
future demand for Treasury securities.

We contribute to the literature that studies the properties of the empirical SDF. The pric-
ing kernel puzzle as described by Beare and Schmidt (2016) documented the inconsistency
between the proposed monotonicity of the SDF by Dybvig (1988) and estimated pricing
kernels for various financial instruments.5 Hens and Reichlin (2012) offered three solutions
to the pricing kernel puzzle: (i) incomplete markets; (ii) alternatives to the risk averse ex-
pected utility for investors; and (iii) incorrect beliefs. These alternatives were also used to
explain the equity premium puzzle of Mehra and Prescott (1985), which demonstrated that
an SDF dependent only on consumption growth is insufficient to explain the excess return on
stocks and the risk-free interest rate. Intuitively, small variation of the risk-free interest rate
implies small variation in the expected SDF; however, high fluctuations in expected stock re-
turns implies that the SDF must be non-linearly related to equity markets. Cochrane (1991)
showed that time variation of the equity premium, predictability of returns, and excess stock
volatility are all derived from the same properties of the expected SDF, and Cochrane (2017)
5
From Beare and Schmidt (2016), given a pricing kernel, π, (i) the SDF is a random variable at a
future time t + 1; (ii) the current price of a financial instrument Yt is given by Et [SDF Yt+1 ]; (iii) M ∗ =
Et [SDF St+1 ], where St+1 is the price of the market portfolio at time t + 1; and (iv) the pricing kernel is
defined such that M ∗ = 1+i1
πt (St+1 ).

3
surveyed this work and proposed that an extra variable that increases risk aversion during
bad times is necessary to capture the time variation of the expected SDF and hence the
equity premium.

Consistent with the literature, our results provide additional evidence of a non-monotonic
SDF or pricing kernel. Non-monotonicity in risk premia has been identified in studies of
combinations of forward rates (Fama and Bliss, 1987; Cochrane and Piazzesi, 2005), Treasury
spreads (Campbell and Shiller, 1991), and equity returns (Parker and Julliard, 2005; Lustig
and Van Nieuwerburgh, 2005; Yogo, 2006; Sousa, 2010); and explained by slow-moving habit
driven by shocks to aggregate consumption (Campbell and Cochrane, 1999; Wachter, 2006),
shocks to inflation (Brandt and Wang, 2003), countercyclicality (Ludvigson and Ng, 2009),
transitory deviations from the common trend among consumption, aggregate wealth and
labor income (Lettau and Ludvigson, 2001), and long-run risk (Bansal and Yaron, 2004),
among other explanations. We show that investors’ strategies to hedge against maturity risk
– which depend on the shape of the yield curve and the mean-reverting properties of interest
rates – also yield a non-linear expected SDF.

II. Non-linearities in Bond Market Valuations

A. Prices of Risk in a Term Structure Model

We begin with a canonical term structure model with observable factors as in Joslin et al.
(2011). The zero-coupon nominal yield to maturity rτ,t is driven by an affine process mapping
the yield of each maturity to a parsimonious number of underlying factors, Yt , such that

rτ,t (Yt ) = Aτ + Bτ Yt , (2)

where the time subscript t corresponds to today’s date and τ is the maturity date. The
parameters Aτ and Bτ for each maturity are set so that there is no arbitrage opportunity
for investors in the bond markets.
h i0
The state vector Yt = Y1t Y2t Y3t contains the set of observable “interest-rate risk”
factors constructed by principal component analysis as weighted averages of the yields for
all the maturities, ytobs , with weight vector W :

Yt = W ytobs .

Fig. 1 shows the U.S. yield curve during the 1975–2017 period in panel (a) and the three
factors extracted by principal component analysis in panel (b). Consistent with the literature

4
identifying the first three principal components to account for over 99% of the cross-sectional
variation in the yield curve, we refer to these factors as “level” (88.5%), “slope” (8.5%) and
“curvature” (2.1%) as in Litterman and Scheinkman (1991). The level factor corresponds to
the average of all yields, the slope factor is 90% correlated with the 10-year–3-month spread,
and the third factor is 70% correlated with the Diebold and Li (2006) definition of curvature,
obs obs obs
y10y,t + y3m,t − 2 ∗ y2y,t . The estimated factors in our term structure model track the empirical
level, slope, and curvature of the yield curve and hence inherit their name.

Figure 1: U.S. Yield Curve and Interest-Rate Risk Factors

(a) Yield Curve

(b) Interest-Rate Risk Factors

Notes: Annualized yield curve data in percentage from 3 months to 10 years from January 1975 to
March 2017 come from Yung (2017). Factors are extracted by principal components analysis as the
eigenvalue-eigenvector decomposition of the variance-covariance matrix of yields.

These factors are assumed to follow an autoregressive process of order one under the actual

5
or physical distribution P,


Yt+1 = K0P + K1P + I Yt + ΣεPt+1 , (3)

where K0P and K1P are constants, I is the identity matrix, and Σ is a lower triangular matrix


obtained from the variance covariance of the innovations to the factors εPt+1 , which are i.i.d.

−1 P
This stochastic process is mean reverting to − K1P K0 , as long as all the eigenvalues of
K1 are strictly negative. If all the eigenvalues are zero, then Eq. (3) is a random walk (with
P

drift if K0P 6= 0). In this case, there is no change in the conditional expected future yields
and hence no benefit to hedging against interest-rate risk. On the other hand, under a mean
reverting stochastic process with K1P < 0, investors expect the factors (and hence yields) to
move back to their long-term unconditional means and therefore adopt hedging positions to
take advantage of these expectations.

The risk neutral distribution Q of the factors satisfies

Yt+1 = K0Q + K1Q + I Yt + ΣεQ
t+1 . (4)

Eq. (4) adjusts the mean of the physical distribution for the price of risk per unit of volatility.6
Thus, bonds of any maturity can be priced as if investors in the bond markets were risk
neutral.

The risk-free interest rate, rt , is also a linear function of the factors:

rt (Yt ) ≡ rt = ρ0 + ρ1 Yt , (5)

such that the constant ρ0 and the vector ρ1 are independent of time.

To determine the price of zero-coupon bonds, the SDF, Mt+1 , is assumed to have the following
exponential quadratic form
 
1 0 0 P
Mt+1 = exp −rt − Λt Λt − Λt εt+1 , (6)
2

so the price of risk that characterizes investors’ attitude toward risk, Λt , is affine in the
6
Following Beare and Schmidt (2016) as in footnote 5, suppose Yt+1 = ft (St+1 ) is the price at time t + 1
of a market
R∞ portfolio for some payoff function ft on a contingent security. Thus, Yt = Et [SDFt ft (St+1 )] =
1 1
1+rt 0 f t (x)q t (x)dx, where q(x) is the risk neutral distribution. Yt = 1+r t
Et [πt (St+1 ) ft (St+1 )] =
1
R ∞ qt (x) ∗
1+rt 0 ft (x)πt (x)pt (x)dx, where pt (x) is the physical distribution. This means πt (x) = pt (x) = M (x)(1 +
rt ).

6
factors,


ΣΛt = K0P − K0Q + K1P − K1Q Yt . (7)

The adjustment for risk in the SDF, − 12 Λ0t Λt , follows from the shocks to the interest-rate
risk factors being a log-normal probability distribution. This risk adjustment is given by

1 1 −1  P
− Λ0t Λt = − K0P0 − K0Q0 + Yt0 K1P − K1Q (Σ0 Σ)



K0 − K0Q + K1P − K1Q Yt . (8)
2 2

Importantly, the logarithm of the SDF exhibits a quadratic shape. This property is a con-
sequence of time-varying interest-rate risk, implying a Gaussian bond risk premium – the
adjustment for maturity risk in bond markets.

We estimate the model parameters using monthly U.S. Treasury yields data from January
1975 to March 2017. In the estimation, we use 12 maturities: 3 and 6 months, 1, 2, 3, 4, 5,
6, 7, 8, 9, and 10 years. An advantage of the two-stage procedure of Joslin et al. (2011) is
that Eq. (3) can be separately estimated by OLS and all other parameters can be rotated
such that the maximum likelihood algorithm immediately converges to the global optimum.

In Fig. 2, we plot the actual yield to maturity relative to the estimated values from the model
for the three-month and five-year bonds. As is standard in the term structure literature, the
model captures the movement in yields over time really well, both in the short and the long
end.

Figure 2: Model Interest-Rate Fit

(a) 3-Month Yield (b) 5-Year Yield

Notes: The three-month and five-year yields in annualized percentage from the data (in black) are compared
to the model-implied yields (in blue) from Eq. (2).

7
 B. The Expected Stochastic Discount Factor

Given the properties of the log normal probability distribution, the expected SDF for in-
vestments paying off in one month and conditional on information at time t, i.e., Yt = Y , is
given by
(  0  )
1 0 −1
Et [Mt+1 |Yt ] ≡ M(Y ) = M1 exp − Y − µM (σM σM ) Y − µM . (9)
2

µM is the mean of the expected SDF, and σM is a lower triangular matrix obtained from
the variance covariance of the innovations to the factors with the corresponding standard
deviations on the diagonal. Taking the conditional expectation converts the shock into a
time horizon-dependent term only, which we include in the constant M1 to simplify the
notation.7

Fig. 3 shows the model-implied one-month expected cashflow valuation function for an
investor, characterized by an SDF as in Eq. (9), conditional on the level M(Y1 ), slope
M(Y2 ), or curvature M(Y3 ) factor moving, while all other factors are held constant at their
stationary values. In each case, the expected SDF exhibits a Gaussian shape centered around
a conditional mean (indicated with the vertical dashed line), along three times its conditional
standard deviation on either side. In the case of the level, the one-month ahead expected
SDF is at its maximum of 0.9978 whenever the level factor is at µlevel
M = 0.0061. From Eq.
(1), this value corresponds to a one-month discount rate of 0.22%.

An increase in the level of the yield curve is associated with higher cashflow valuations only
level
when the level change occurs from the left of the conditional mean, i.e. ∆Yt→t+1 < 0.0061. If
level
the level increases from the right of the conditional mean, ∆Yt→t+1 > 0.0061, then investors’
expected SDF actually decreases. Similarly, the expected SDF is at its maximum of 0.9597
whenever the slope factor is at µslope
M = 0.0023 and 0.9902 whenever the curvature factor is
curve
at µM = 0.0011.

In practical terms, this framework can be used to quantify how changes in the level, slope,
and curvature impact investors’ expected SDF. Two takeaways emerge. First, the effect on
expected cashflows depends on the current state of the yield curve and hence the economy.
In other words, investors discounting function depends on how interest-rate risk factors
0 0 0 0 0
7
M1 = exp{−(ρ0 + 21 (K0P − K0Q ) Σ−1 Σ−1 (K0P − K0Q )) + 21 (ρ1 + (K0P − K0Q ) Σ−1 Σ−1 (K1P − K1Q ))( 12 (K1P −
Q 0 −10 −1 0 0 0
K1 ) Σ Σ (K1P − K1Q ))−1 (ρ1 + (K0P − K0Q ) Σ−1 Σ−1 (K1P − K1Q ))}. See Cosimano and Yung (2019) for the
discrete-time derivation of the expected SDF for any horizon k = {1, ..., K} in months and Cosimano and
Ma (2018) for the continuous-time counterpart.

8
change, relative to the conditional mean of the expected SDF. Second, investors’ expected
SDF depends on movements across the entire maturity spectrum; hence decomposing the
impact of interest rates by one factor at a time helps understand the net effect of different
yield curve shapes on bond valuation through the non-linear risk adjustment in investors’
expected SDF.

Figure 3: Expected SDF versus Level, Slope and Curvature

Notes: Each plot shows the one-month expected SDF conditional on each factor moving, while the
others are held constant, as given by Eq. (9), where the dashed line represents the value at which the ex-
pected SDF is at its conditional mean µM and the conditional standard deviation is indicated in parentheses.

C. Application: The November 2016 Change in Yields

We now consider the movement in interest rates following the 2016 U.S. presidential elections.
Fig. 4(a) shows the 3-month to 10-year Treasury yield curve on October 31, 2016 (gray) and
November 30, 2016 (blue). The pronounced change in the shape of the yield curve reflects
investors’ reassessment of the future course of the economy, in this case marked by higher
interest rates and a salient steepening of the yield curve. In terms of interest-rate risk factors,
the level increased by 35%, the slope steepened by 40%, and the curvature went up by 15%.

In order to study the implications of these movements on investors’ discounting of future

expected cashflows, panels 4(b), (c), and (d) show the impact of the level, slope, and

9
curvature by zooming into the specific range through which the factors have historically
moved since 1975. In all three cases, the factors moved towards their unconditional means
(Ȳlevel = 0.012, Ȳslope = 0.0024, Ȳcurve = 0.0009).

Figure 4: Investors’ Discounting as Interest-Rate Risk Factors Change

(a) Yield Curves (b) Expected SDF with Level Change

(c) Expected SDF with Slope Change (d) Expected SDF with Curvature Change

Notes: Panel (a) shows the U.S. Treasury yield curve for October 31, 2016 and November 30, 2016 from 3
months to 10 years. Panels (b), (c), and (d) show the expected SDF conditional on either the level, slope, or
curvature factor moving, while all other interest-rate risk factors are held constant, as a zoomed-in version
of Fig. 3. The corresponding yield curve changes are shown along with the factors’ steady state values (Ȳ )
and the expected SDF conditional means (µM ).

Typically, an increase in the level of the yield curve implies a decline in investors’ discounting
function, as it is likely to occur from the right of the conditional mean of the expected
SDF. However, given that interest rates have been at historic lows, the increase in the level

10
happened from the left of the conditional mean, implying an increase in investors’ valuation
of cashflows. For this particular event, the steepening of the yield curve and the increase
in the curvature also increased the expected SDF, as the factors moved from the left of the
conditional mean. Thus, this specific movement in the yield curve following the results of the
U.S. presidential elections led to an overall increase in the expected value of future cashflows
received by investors in the bond market.

III. Investors’ Risk Aversion and Portfolio Positions

We obtain the equilibrium expected return on Treasury securities as a linear function of
the interest-rate risk factors, the supply of Treasury securities, and the average leverage
of investors in the market for Treasuries. The dependence on the interest-rate risk factors
reflects Merton’s hedging demand.8 In equilibrium, the coefficients on these factors are an
average of the responses by all the investors in the economy, which we can think of as the
marginal investor’s response to changes in interest rate risk.

A. Portfolio Rules
Chami et al. (2017) and Cosimano and Ma (2018) show that the discrete-time model for
the factors can be transformed into a continuous-time stochastic process allowing the factors
to coincide at each date of observation, i.e. X(s) = Yt . This mapping allows us to derive
the probability distribution for unobservable interest-rate risk factors estimated by Kalman
filter over any given time horizon.

The continuous time stochastic process for the factors is

dX(s) = γ P − AP X(s) ds + ΣX ds ,

 

where s is a Brownian motion and the mapping from the discrete-time to the continuous-
time model is given by
 −1
P P P −AP


A = − ln K1P +I and γ = A I −e K0P .

In addition, the continuous-time equivalent price of risk is now given by

Λ (X(s)) = (ΣX )−1 γ P − γ Q − (ΣX )−1 AP − AQ X(s),

(10)
8
This demand is based on a comparison of the current factors with the expected utility desired by each
investor; which is scaled by the variance-covariance matrix for the investor’s expected utility and multiplied
by the beta from regressing the return on Treasury securities on the risk factors.

11
where γ Q and AQ are risk-adjusted parameters such that the variance-covariance matrix of
0
the residuals, ΣX ΣX , is invariant across both distributions, following the diffusion invariance
principle (Girsanov, 1958). The excess holding period return on a zero coupon security with
maturity τ , where Pτ,s is the price, is given by

dPτ,s
− r(s) =bτ (γ P − γ Q ) −(AP − AQ )X(s) ds + bτ ΣX ds
 
(11)
Pτ,s
= [µτ (s) − r(s)] ds + bτ ΣX ds .

bτ is a constant proportional to the bond pricing coefficient, Bτ , r(s) is the continuous-time

risk-free rate and µτ (s) is the expected return on a maturity-τ bond.

Let investors who take Eq. (11) as given be grouped into J investment buckets. Without
loss of generality, each bucket of investors j = 1, ..., J chooses how to optimize a portfolio
with U.S. Treasury securities of different maturities τ = {1, 2, ..., n}, subject to a liquidity
constraint that limits the percentage invested in these securities to ξ j . Investors have a
constant relative risk aversion coefficient, γ j , and seek to maximize expected lifetime utility
over a fixed terminal wealth at time horizon hj . W j is the sum of total investment by all
investors in bucket j.9

The total demand for Treasury securities, D(s), is

J
X
D(s) = ω j (s)W j , (12)
j=1

where ω j (s) is the optimal percentage of wealth invested by the j th investor:

 
j 1 j j j j 0 −1

 j

ω (s) = j ω1 (µ(s) − µτ (s)ι) + ω1 ω2 ξ + ω1 ω3 γ σj (h )σj (h ) X(s) − µj (h ) ,
γ | {z } | {z } | {z }
Sharpe Ratio Leverage Hedging Demand Against Interest-Rate Risk
(13)
for ω1j (s) j 0 j
= ξ − ι ω (s) representing the wealth invested on the 1 st
bond, where ι0 =
(1 ... 1).10

The terms ω1 , ω2 , ω3 are constants defined as follows:

ω1 ≡ [bΣX Σ0X b0 + ιι0 bτ ΣX Σ0X b0τ − 2bΣX Σ0X b0τ ι0 ]−1 ,

9
By limiting the utility function to a constant relative risk aversion coefficient we know that the non-
linearity of the expected SDF arises from the hedging behavior of investors.
10
For derivations see Chami et al. (2017) and Cosimano and Ma (2018).

12
 ω2 ≡ 2 (bΣX Σ0X b0τ − ιbτ ΣX Σ0X b0τ ) ,

ω3 ≡ (b − ιbτ ) ΣX Σ0X .

b0 = [b2τ ... bnτ ] is a vectorhof bond price elasticitiesi with respect to the interest-rate risk
factors, such that b0 − ιbτ = b2τ − bτ ... bnτ − bτ captures the elasticity of the 2nd to
nth bond relative to the elasticity of the 1st bond, bτ .

The first term in portfolio rule Eq. (13) is the traditional Sharpe ratio adjusted for investors’
coefficient of relative risk aversion γ j . The expected return on the 2nd to nth bond, µ(s)0 =
[µ2τ (s) ... µnτ (s)] relative to the 1st bond, µτ (s), is given by

µ(s) − µτ (s)ι ≡ (b − ιbτ ) (γ P − γ Q ) −(AP − AQ )X(s) .

 
(14)

Notice that the excess return on bonds is measured relative to the 1st Treasury security
in Eq. (14), rather than the risk-free rate as in Eq. (11). Consequently, the price of risk
(γ P − γ Q ) −(AP − AQ )X(s) from Eq. (10) is multiplied by the relative bond elasticity
parameters, b − ιbτ . The ω1 term in the Sharpe ratio adjusts the variance-covariance of the
last n − 1 bonds, bΣX Σ0X b0 , by the variance of the first bond, bτ ΣX Σ0X b0τ and the covariance
of the last n − 1 bonds with the first, bΣX Σ0X b0τ .

The second term in Eq. (13) is an adjustment to ensure that the portfolio weights add up
to ξ j , so that leverage is limited. The term ω1 ω2 represents the coefficient from regressing
the excess return for the last n − 1 bonds against the return for the first bond.

The last term in portfolio rule Eq. (13) is the hedging demand for Treasury securities from
Merton (1969, 1971), which arises under mean reverting factors, given that K1P < 0. The term
ω1 ω3 is the ratio of the covariance between excess returns and the estimated interest-rate risk
factors relative to the variance-covariance of excess returns. As a result, it can be interpreted
as the beta coefficient from regressing expected excess returns on bonds on the lifetime utility
of the investor. µj (hj ) represents the mean of the investors’ expected utility. σj (hj )σj (hj )0
is the variance-covariance matrix for the investor’s expected utility, where σj (hj ) is a lower
triangular matrix such that the diagonal elements are the standard deviations of the investor’s
−1
expected utility for each factor. With these definitions, γ j (σj (hj )σj (hj )0 ) [X(s) − µj (hj )]
captures the sensitivity of the expected lifetime utility for investor j with respect to the
factors. This latter term can be interpreted as the risk adjusted duration of investors’
portfolio for horizon hj . If the factor X(s) is equal to the expected mean of the investor’s

13
utility, µj (hj ), then there is no benefit to hedging interest-rate risk, whereas the hedging
demand is positive for X(s) > µj (hj ) and negative for X(s) < µj (hj ).

To sum up, the investment strategy’s expected return is a function of the estimated interest-
rate risk factors, such that interest-rate risk shocks impact the decisions of the investor as
she re-balances her portfolio of Treasury securities.

To evaluate the impact of yield curve moves on the investor’s capital gains, we consider the
case for two particular investor buckets j = 1, 2 with different levels of risk aversion. For
simplicity, let all investors choose the optimal allocation of their wealth between a 3-month
and a 5-year bond to maximize expected lifetime utility for an investment horizon of hj = 1
year. We assume, for each investor, a subjective discount rate of 5%, leverage ratio ξ j = 1,
and estimate all parameters for the January 1999–December 2007 period as in Chami et al.
(2017). While the first bucket of investors has a higher aversion to risk, i.e., γ j=1 = 10, the
second investment group is less risk averse, i.e., γ j=2 = 5. For this shorter time period, the
unconditional means are (X̄level = −0.0177, X̄slope = −0.0159, X̄curve = 0.0045).

The more risk averse investor’s expected lifetime utility is a Gaussian function with con-
ditional mean µj=1 (hj=1 = 1) = −0.0593 and standard deviation σj=1 (hj=1 = 1) = 0.1512
for changes in the estimated level of the yield curve, while holding all other factors con-
stant. The conditional mean is µj=2 (hj=2 = 1) = −0.0567 and the standard deviation is
σj=2 (hj=2 = 1) = 0.1197 for the less risk averse group. A similar pattern arises for the gross
rate of growth for the investor’s wealth.11

Fig. 5 shows investors’ portfolio allocation strategies given their risk aversion, conditional
on the estimated level of the yield curve changing, while all other factors are held constant
at their steady state values. When the estimated level of the yield curve is at its steady state
X level = −0.0177, the more risk averse investor allocates 46% of her wealth to the 3-month
bond (solid blue) and 54% to the 5-year bond (solid orange).12 The demand due to hedging
risk is 46%, so that only 8% of the investor’s wealth is allocated to the 5-year bond based
on the Sharpe ratio and leverage constraint. The less risk averse investor places 86% of her
wealth into the 5-year bond (dashed orange) with 14% in the 3-month bond (dashed blue).
Of the 86% of the investor’s wealth in the 5-year bond, 69% is due to the hedging demand.
11
The gross rate of growth for investors’ wealth has conditional mean −0.0640 and standard deviation
0.1065 for the more risk averse group; and conditional mean −0.0366 and standard deviation 0.0798 for the
less risk averse group.
12
Changing the discount rate has a small impact on the portfolio decision of the investor. For example, a
discount rate of 10% instead of 5%, leads to a 48-52% allocation, compared to 46-54%.

14
 Figure 5: Portfolio Positions Conditional on the Estimated Level of the Yield Curve

Notes: The solid lines indicate the portfolio weights of a risk-averse investor (γ = 10) that chooses wealth
allocation between a 3-month bond (blue) and a 5-year bond (orange), for different values of the estimated
level, holding all other factors constant. The dashed lines represent the portfolio weights of a less risk averse
investor (γ = 5). In both cases, leverage is limited (ξ j = 1) and the investment horizon is one year (hj = 1).

If the estimated level is higher than its steady state value, X level > −0.0177, anticipated
mean reversion implies that the investor expects the level of the yield curve to fall, and
hence longer-duration bonds would lead to a larger capital gain. As a result, the portfolio
is longer on 5-year bonds and shorter on 3-month bonds during high interest-rate periods,
as in the example, with the less risk averse investor allocating 86% to the 5-year bond and
14% to the short term bond. If the random change in the level is, however, positive, then
the investor would suffer a larger capital loss. The portfolio position is reversed in a low
interest rate environment, X level < −0.0177, since mean reversion implies that the investor
expects the level of the yield curve to move back to its steady state value and the portfolio
is therefore shorter on longer term bonds. If the random change in the level is negative
and hence declines even further, then the investor suffers a capital loss. In the case of
µj=1 (hj=1 = 1) = −0.0593 < −0.0177, the more risk averse investor places −113% of her
wealth in 5-year bonds and 213% in the 3-month bond. This allocation is accomplished with
no hedging demand, since the investor is at the maximum expected utility conditional on
the estimated level of the yield curve. Thus, these allocations are based on the Sharpe ratio
and the leverage constraint from Eq. (13).

15
We also consider the portfolio positions of a second bucket of investors with a lower aversion
to risk (dashed lines). These two types of investors could be representative, for example,
of the investment positions of small and large banks, respectively, since the smaller banks
would have less wealth and a higher risk aversion (i.e. γ j=1 = 10.). The investor with a lower
aversion to risk increases the magnitude of the bet on the level of the yield curve reverting to
its steady state value. This implies that the less risk averse investor will choose a portfolio
with higher duration in a high interest rate environment, relative to the investor that is more
risk averse.

The portfolio position is reversed in the lower interest rate environment, X level < −0.0177,
since mean reversion implies that the investor expects the level of the yield curve to move
back to its steady state value. This expectation implies that the investor anticipates the
bonds to have a capital loss (as the price of the bond decreases) and this capital loss is
higher for the longer term bond. If the random change in the level is negative and hence
declines even further, then the bond would receive a capital gain (as the price of the bond
goes up). As a result, the investor goes short the five-year bond and long the three-month
bond. Consequently, the investor expects to have a capital gain when the level of the yield
curve moves back to its mean. See the blue lines in Fig. 5 under the low interest rate
environment. This behavior is exaggerated by the less risk averse investors, the blue dashed
line, since they are more willing to take on risk for a higher rate of return.

During an even lower interest rate environment –from June 2008 to December 2016– the
level of the yield curve for which the expected utility of wealth is maximized is smaller, since
µj (hj ) would be smaller. In this case, the portfolio positions in Fig. 5 would all shift to
the left, but would not change their relative positions, because these portfolio positions are
linear in µj (hj ). The investors behave this way, since they have lowered their estimate of
the level for the yield curve in the lower interest rate environment.

B. Hedging Strategies in a Low interest Rate Environment

We next illustrate how the Treasury market for each maturity clears given the optimal
portfolio behavior discussed in the previous section. Let S(s) be a vector for the supply of
Treasury securities in the bond markets at each maturity provided by the decisions of the
U.S. Treasury and the Federal Reserve Board. Consequently, the equilibrium condition in
the market for Treasury securities is given by

D(s) = S(s).

16
For simplicity, suppose the inverse of ω1 exists, so that the number of independent securities
is the same as the number of interest-rate risk factors (otherwise, we would have to use its
pseudo inverse). Then from Eqs. (12) and (13), we find that the expected excess return on
bonds is dependent on the behavior of all the investors in the Treasury market in equilibrium:

( J
1 −1
X
−1 Wj
µ(s) − µτ (s)ι = PJ Wj
(ω1 ) S(s) + ω3 γ j σj (hj )σj (hj )0 µj (hj )
j=1 γ j j=1
γj
J J
)
j j
XW X −1 W
ξ j j − ω3 γ j σj (hj )σj (hj )0


− ω2 j
X .
j=1
γ j=1
γ

Wj
PJ
j=1 γ jis the sum of the inverse of the absolute risk aversion coefficients across all investors,
−1 j
such that PJ 1 W j Jj=1 (σj (hj )σj (hj )0 ) µj (hj ) Wγ j is the weighted average of the desired
P
j=1 γ j
−1 j
Sharpe ratio and PJ 1 W j Jj=1 (σj (hj )σj (hj )0 ) Wγ j is the weighted average of the market
P
j=1 γ j

portfolio’s variance.

1
Define θ ≡ PJ Wj
to be one divided by the sum of the inverse of the absolute risk aversion
j=1 γ j
j
of all investors, while θj ≡ Wγ j θ is the individual investor’s contribution to this value. The
price of risk coefficients from Eq. (14) in equilibrium are as follows:

J J
X X
−1
(b − ιbτ ) (γ P − γ Q ) = θ (ω1 )−1 S(s) − ω2 θj ξ j + ω3 θj γ j σj (hj )σj (hj )0 µj (hj ),
j=1 j=1

(15)

J
X
−1
(b − ιbτ ) (AP − AQ ) = ω3 θj γ j σj (hj )σj (hj )0 . (16)
j=1

Eq. (15) is the constant in risk pricing Eq. (14). This term is positively related to the
quantity of Treasury securities made available to the markets, weighted by total absolute
risk aversion. This constant is also negatively related to the leverage ratio of all investors,
weighted by absolute risk aversion relative to its value for the marginal investor. Given that
PJ j
j=1 θ = 1, we can think of these weights as the probability distribution of the inverse
of the absolute risk aversion for each group of investors in the Treasury markets. In this
case Jj=1 θj ξ j is the mean value of the leverage constraint for the probability distribution
P

17
of investors. Finally, the last term in Eq. (15) is related to the expected lifetime utility for
each bucket of investors in the market, adjusted for the investor’s coefficient of risk aversion.
This effect is multiplied by the covariance between the expected excess return on bonds
and the interest-rate risk factors, ω3 . Thus, this last term captures how much a change in
interest-rate risk factors influences the risk adjusted return on all investors’ expected lifetime
utility; and can hence be interpreted as the amount of risk in the market when factors are
at their steady state values.

Eq. (16) represents the slope of the price of risk in the Treasury market, which captures how
changes in interest-rate risk factors impact expected excess returns through the marginal
investor’s variance-covariance of her expected utility. This term is amplified by ω3 and the
absolute risk aversion for investors in each bucket. If we combine the last term in Eq. (15)
with Eq. (16) times the current yield curve factors, we then obtain the impact of the hedging
demand on the equilibrium excess return on bonds

J
X
−1
γ j θj σj (hj )σj (hj )0 X − µj (hj ) .


Hedging = ω3 (17)
j=1

Thus, the expected excess return is negatively related to the expected current factors
−1 −1
(σj (hj )σj (hj )0 ) X relative to the conditional mean (σj (hj )σj (hj )0 ) µj (hj ) desired by the
investors in bucket j.

Notice that while the portfolio position of investors is dependent on their constant relative
risk aversion γ j , the price of risk for the Treasury market is also a function of their wealth
W j and hence, the probability distribution for absolute risk aversion for investors (defined
as γ j /W j ). In addition, if the coefficient of relative risk aversion is fixed, then the less
wealthy investor takes on a portfolio of Treasury securities that has less longer-term Treasury
securities to reduce their risk.

For the market, we can find the equilibrium return as the fixed point of Eqs. (15) and
(16) with the two types of investors (γ = 10 and γ = 5). In Fig. (6), we show each
investor’s expected lifetime utility conditional on the estimated level of the yield curve to
emphasize the difference in the position of the two investors at a fixed point. Each investor
has a maximum expected lifetime utility under their optimal portfolio strategy, which occurs
when the estimated level of the yield curve is −0.0593 for the more risk averse investor (red)
and −0.0567 for the less risk averse investor (black). These maxima are 0.9757 at point
A and 0.9738 at point B for each corresponding investor. From Fig. 5, we know that the
duration of the portfolio for the more risk averse investor is always higher relative to the

18
less risk averse investor. In addition, the Gaussian functions of the expected lifetime utility
have a standard deviation of 0.1512 for γ = 10 and 0.1197 for γ = 5, so that the dispersion
is larger for the more risk averse group.

Figure 6: Finding the Equilibrium Return with Two Investors

Notes: Expected lifetime utility is depicted in red for an investor with high risk aversion (γ = 10) and in
black for an investor with low risk aversion (γ = 5). Point A and B represent their mean, respectively,
conditional on the estimated level of the yield curve.

We can now discuss properties of the equilibrium in the bond markets. Initially we consider
a market in which there is zero net supply among the investors. For the excess returns in
the Treasury market to be in equilibrium, it must be the case that the distribution across
the two investors implies that one investor is shorter and the other is longer on longer-term
Treasury securities. This means the market equilibrium cannot be to the left of point A or
to the right of point B in Fig. (6). In particular, we see in Fig. (6) that if the equilibrium is
between points A and B, the more risk averse investor, A, is long in the long-term Treasury
securities, while the less risk averse investor is short the long-term Treasury securities. This
result occurs since the more risk investor expects the level factor to fall which yields a bigger
capital gain in long term government securities. If S(s) is sufficiently positive, both investors
will be long the long-term Treasury securities, but the more risk averse investor would be
even longer on these securities.

Now consider an unanticipated increase in the estimated level of the yield curve during a low
interest rate environment. In such an environment, investors with a higher level of absolute

19
risk aversion (investors γ = 10) would be long on long-term Treasury securities relative to the
less risk averse investors (investors γ = 5). As a result of the interest rate increase, γ = 10
investors would suffer a capital loss, while γ = 5 investors would experience a smaller capital
γ=5 | γ=10 |
loss |∆W
W γ=5
< |∆W
W γ=10
for W γ=5 > W γ=10 . Hence, the absolute risk aversion increases more
for the more risk averse investors and widens the spread between more and less absolute
γ
∂W
risk investors. In particular, Wγ ∂W = −1, so that a percentage change in wealth leads to
W
the same percentage decrease in the level of absolute risk aversion. Thus, an increase in the
estimated level of the yield curve in this case, implies a decrease in hedging behavior by the
more risk averse investors relative to the less risk averse investors.

IV. Conclusion
Using a no-arbitrage asset pricing model for the U.S. Treasury market, we describe how
the critical nature of the non-linearities in the SDF matters for the transmission of interest
rate risk across investors’ portfolio positions. Whenever interest-rate risk factors move away
from the conditional mean of the expected SDF,this leads to a decline of all expected future
cashflows. During the November 2016 U.S. presidential elections, we find that cashflow
valuations increased as the factors reverted back towards their mean.

We illustrate the impact of the variation of discount rates on individual portfolio choices,
by solving for the optimal portfolio of investors that base their decisions on the expected
bond market SDF derived from the no-arbitrage model. When the interest-rate risk factors
are above their long-term mean, investors go long on long-term bonds, since they anticipate
a future fall in the factors leading to a bigger capital gain. These portfolio positions are
reversed when the factors are below their means as investors anticipate increases in the
factors. Finally, we show that the estimated no-arbitrage model of the term structure is an
equilibrium in which all investors follow the optimal portfolio rules with different degrees
of absolute risk aversion. In this equilibrium, the more risk averse investors have a longer
position in long-term bonds relative to the less risk averse investors. Thus, the more risk
averse investors suffer a larger capital loss from the average increase in interest rates, which
leads to a larger increase in the absolute risk aversion.

Our findings suggest that interest rate risk exposure has direct and indirect effects on the
bond markets. First, we identify changes in the entire yield curve to influence the mar-
ket prices of risk non-linearly depending on the current value of interest-rate risk factors
relative to their historical averages. Second, we find that changes in the yield curve also
influence portfolio positions by changing the distribution of investors’ absolute risk aversion
in equilibrium, amplifying the risk exposure of risk-averse or less wealthy investors.

20
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