Supply and Demand and the Term Structure of Interest Rates

Abstract

We survey the growing literature emphasizing the role that supply and demand forces play in shaping the term structure of interest rates. Our starting point is the Vayanos and Vila model of the term structure of default-free bond yields, which we present in both discrete and continuous time. The key friction in the model is that the bond market is partially segmented from other financial markets: The prices of short-rate and bond supply risks are set by specialized bond arbitrageurs who must absorb shocks to the supply and demand for bonds from other preferred-habitat agents. We discuss extensions of this model in the context of default-free bonds and other asset classes.