2012 Reports

Uninsurable Risk and the Determination of Real Interest Rates: An Investigation Using UK Indexed Bonds

Barr, David; Basu, Parantap; Wada, Kenji

This paper investigates the empirical performance of a new class of uninsurable risk models in the context of UK indexed bond market. Using closed form expressions for pricing kernels, we test the ability of three consumption-based models to price indexed bonds in the UK, and find that the standard general equilibrium, complete markets model is soundly rejected in favour of two uninsurable-risk models. Using the estimated bond price equation, impulse response analysis is undertaken to understand the effects of three macroeconomic fundamental shocks on real interest rates. In contrast to the estimates that typically arise in equity markets, the estimated coefficient of relative risk aversion is found to be small in this class of models with uninsurable risk.