Expected Consumption Growth, Stochastic Volatility and Bond Risk Premium

This paper estimates a joint econometric model of consumption growth and long-term real interest rates with stochastic volatility based on data from the U.K. The model imposes no-arbitrage condition on the term structure of real interest rates and extends the standard long-run risk model which assumes constant market prices of risk. We find that both the long-run consumption risk and the volatility risk are priced in long-term real bond yields. The long-run consumption risk dominates the volatility risk and drives most of the movements of bond risk premiums. In contrast to the standard long-run risk model, we find that a counter-cyclical time-varying market price of risk, not the stochastic volatility, is the primary source of time-variations in bond risk premiums, accounting for more than 70% of the variance of the risk premium on the 10-year real bond. JEL Classification: G12, E43