EQUILIBRIUM TERM STRUCTURE RELATIONS OF RISKY ASSETS IN INCOMPLETE MARKETS

This paper presents a simple theoretical model of the term structure a nd analyzes the relations among optimal portfolio decisions, the real term structure of asset returns, and the risks and price volatilities of assets with different terms to maturity. It is argued that specifyi ng utility to be a non-time-separable function of consumption allows f or richer term structure relations than separable specifications The m odel is capable to explain why term premiums vary and why the term str ucture may fail to be monotone. Our analysis also demonstrates that th e competitive mechanism tends to undervalue short-term risks relative to long-term risks if the investors have short planning horizons.