Uninsurable Risk and the Determination of Real Interest Rates: An Investigation using UK Indexed Bonds

This paper investigates the empirical performance of a new class of consumption-based, uninsurable risk models in the context of UK indexed bond market. Using closed form expressions for pricing kernels, we test the ability of three consumption-based models to …t the market prices of indexed bonds in the UK. The classical general equilibrium model performs reasonably well, in contrast to its performance in equity-pricing exercises, but is marginally outperformed by models that limit the availability of insurance. A model that prohibits all insurance appears to perform marginally better than a model that permits partial insurance. In contrast to the estimates that typically arise in equity markets, the estimated coe¢ cient of relative risk aversion, and the resulting bond risk premia. are found to be small in the indexed bond market. The estimated price equations are used to calculate impulse responses illustrate the e¤ects of various macroeconomic shocks on real interest rates. David Barr and Parantap Basu are at Durham University, United Kingdom. Kenji Wada is at Keio University, Japan. We like to thank Motonari Kurasawa, Akihito Toda and the participants at the 2009 NFA conference, 2008 Daiwa International Workshop on Financial Engineering, workshops at Singapore Management University, Yokohama National University and Jadavpur University for helpful comments. Wada gratefully acknowledges the Grant-in-Aid for Scienti…c Research from the Ministry of Education, Culture, Sports, Science and Technology of Japan.The usual disclaimer applies.