Rational Expectations Model of Term Premia with Some Implications for Empirical Asset Demand Equations

  • Author(s): CARL E. WALSH
  • Published: Apr 30, 2012
  • Pages: 63-83
  • DOI: 10.1111/j.1540-6261.1985.tb04937.x

ABSTRACT

This paper derives the equilibrium time series processes characterizing the prices of bonds which differ by maturity using the CAPM relationship between expected returns. The assumption of rational expectations requires that asset demand behavior, which determines bond prices in equilibrium, be based on the covariances among returns that are implied by the assumption of market clearing. This requirement imposes nonlinear restrictions on the parameters in the solution for bond prices. Some implications for the types of comparative static exercises for which it is legitimate to assume invariant demand functions are discussed, and some numerical solutions for bond prices are derived.

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