Risk Premiums in the Portuguese Treasury Bills Interest Rates from 1990 to 1998:
An ARCH-M Approach
José Alberto Soares da Fonseca
GEMF/Faculdade de Economia, Universidade de Coimbra
One central subject in the literature on the term structure of interest rates is the empirical evidence about risk premiums and their stochastic processes. The traditional theory of the term structure accepted that risk premiums where zero or monotonically increasing with bonds’ maturity.
The new dynamic approach based on intertemporal equilibrium developed by Vasicek (1977), Cox, Ingersoll and Ross (1985) and others, has demonstrated that risk premiums are not proportional to bonds’ maturity, but to the stochastic risk measure of the bond. However, in some of those models it is accepted that the market price of risk is constant over time. A significant change in the theoretical analysis of risk premiums has occurred with the study of Longstaff and Schwartz (1992), according to which the term structure is explained by the stochastic processes followed by a short-term interest rate and its volatility.
One of the main objectives of the present research is to study the (non) stationarity of the series of the Portuguese Treasury bills rates during the 1990s, and the influence on their autoregressive process, of ERM crises, and the convergence criteria for stage 3 of EMU. The other objectiv is to determine the existence of forward and return premiums and their time variability. An ARCH-M(1) model has revealed to present good explanatory power about the process followed by those premiums.