Book contents
- Frontmatter
- Dedication
- Contents
- Acknowledgements
- Symbols and Abbreviations
- Part I The Foundations
- Part II The Building Blocks: A First Look
- Part III The Conditions of No-Arbitrage
- 11 No-Arbitrage in Discrete Time
- 12 No-Arbitrage in Continuous Time
- 13 No-Arbitrage with State Price Deflators
- 14 No-Arbitrage Conditions for Real Bonds
- 15 Links with an Economics-Based Description of Rates
- Part IV Solving the Models
- Part V The Value of Convexity
- Part VI Excess Returns
- Part VII What the Models Tell Us
- References
- Index
15 - Links with an Economics-Based Description of Rates
from Part III - The Conditions of No-Arbitrage
Published online by Cambridge University Press: 25 May 2018
- Frontmatter
- Dedication
- Contents
- Acknowledgements
- Symbols and Abbreviations
- Part I The Foundations
- Part II The Building Blocks: A First Look
- Part III The Conditions of No-Arbitrage
- 11 No-Arbitrage in Discrete Time
- 12 No-Arbitrage in Continuous Time
- 13 No-Arbitrage with State Price Deflators
- 14 No-Arbitrage Conditions for Real Bonds
- 15 Links with an Economics-Based Description of Rates
- Part IV Solving the Models
- Part V The Value of Convexity
- Part VI Excess Returns
- Part VII What the Models Tell Us
- References
- Index
Summary
Financial economists like ketchup economists […] are concerned with the interrelationships between the prices of different financial assets. They ignore what seems to many to be the more important question of what determines the overall level of prices.
– Summers, 1985, On Economics and FinanceTHE PURPOSE OF THIS CHAPTER
If this book were a novel, the risk premium would clearly be one of its central characters, and this chapter would be a pause in the fast-paced plot, where the author takes a breather and regales the reader with illuminating flashbacks about the childhood of the hero. So, this chapter will not change the plot of the book, but will help the reader understand why its main character (the risk premium) behaves the way it does. More specifically, recall that Chapter 11 gave a very ‘constructive’ derivation of the no-arbitrage conditions, which were obtained by building a very tangible risk-less portfolio, invoking no-arbitrage, and reasoning from there what the ability to do so entailed. Chapter 12 then employed a much more abstract (and general) treatment that starts from the ‘virtual’ prices that the representative investor would assign to some special hypothetical securities. Finally, we looked at the condition of no-arbitrage with real (inflation-linked) bonds. In all of this, we have strictly engaged in ketchup economics (see the quote by Summers, 1985 that opens the chapter). Now we want to take a brief look at what the price of ketchup should be, not which price two bottles of ketchup should fetch, given the price of one (or three) bottles.
What does this mean in practice? When it comes to risk premia, we can try to establish what consistency relationships they should obey (this is the one-bottle/two-bottles bit); we can describe them empirically; or we can try to explain them – which means, we can try to explain why there should be a risk premium at all, whether it should be positive or negative, how large it should be, to which quantities it may be related, and why so.
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- Information
- Bond Pricing and Yield Curve ModelingA Structural Approach, pp. 241 - 260Publisher: Cambridge University PressPrint publication year: 2018