Understanding the real rate conundrum: An application of no-arbitrage models to the UK real yield curve

Abstract

During 2004 and 2005, long-horizon interest rates fell sharply in major international government bond markets (Greenspan's "conundrum"). This common fall mainly reflected lower long real rates. To investigate possible causes, the authors apply a no-arbitrage affine modeling framework to understanding the UK real term structure. The authors find that time-varying term premia are important in explaining movements in long real forward rates. And, although there is evidence that long-horizon expected short real rates declined over the conundrum period, the authors' results suggest that lower term premia played the dominant role. This could be consistent with the so-called "search for yield" and excess liquidity explanations for the conundrum. © The Authors 2011. Published by Oxford University Press [on behalf of the European Finance Association]. All rights reserved.