Restrictions on risk prices reshape expectations and drive interest rate changes.
Restrictions on risk pricing in dynamic term structure models help connect interest rate changes over time and across different rates. A new econometric framework was developed to estimate these models, focusing on level and slope risks in U.S. Treasury yields. By incorporating these restrictions, the model shows that short-rate expectations are more variable than previously thought, explaining the stability puzzle. The decline in long-term interest rates is largely due to expectations of future short rates, in line with conventional wisdom.