Why Does the Market Price of Risk Depend on the Slope of the Yield Curve?

Abstract

We present a simple model that can account for the salient empirical features of the well-docuemented dependence of excess returns in Treasuries on the slope of the yield curve. In the model we propose, investors guess correctly the direction of changes in the path of the target rate decided by the monetary authorities, but systematically overreact. We show that a small degree of overreaction is enough to give rise to a statistically significant dependence of excess returns on the slope of the yield curve.