The Price and Quantity of Interest Rate Risk

Studies of time-varying government bond risk premia that do not account for corresponding time variation in bond risk are incomplete. This paper provides evidence that (1) bond risk premia are solely compensation for bond risk, as no-arbitrage theory predicts, (2) both bond return volatility and the price of that risk vary stochastically, and (3) there is an important time-varying second factor in expected returns. We estimate the joint dynamics of the volatility and the Sharpe ratio of returns on the first and second principal-component bond-factor portfolios in both the US and China. In all four cases, volatility dynamics play a fundamental role in the dynamics of risk premia, and bond factor Sharpe ratios vary stochastically. In the US, VIX is a significant predictor of bond factor volatility and price of risk, incremental to yield-curve level, slope, and curvature