RETURN GENERATING PROCESS AND THE DETERMINANTS OF TERM PREMIUMS

This paper examines asset pricing theories for treasury bonds using lo nger maturities than previous studies and employing a simple multi-fac tor model. We allow bond factor loadings to vary over time according t o term structure variables. The model examines not only the time varia tion in the expected returns of bonds but also their unexpected return s. This allows us to explicitly test some asset pricing restrictions w hich are difficult to study under existing frameworks. We confirm that the pure expectation theory of the term structure of interest rates i s rejected by the data. Our empirical study of a two-factor model find s substantial evidence of time-varying term-premiums and factor loadin gs. The fact that factor loadings vary with long-term interest rates a nd yield spreads suggest that bond return volatilities are sensitive t o interest rate levels.