Indrajit Mitra and Yu Xu
Working Paper 2020-20
November 2020

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Abstract: We present a theory in which limited risk sharing of idiosyncratic labor income risk plays a key role in determining the dynamics of interest rates. Our production-based model relates the cross-sectional distribution of labor income risk to observable aggregate labor market variables. Our model makes two key predictions. First, it predicts positive risk premia for long-term bonds while simultaneously matching key macroeconomic moments. Second, it predicts a negative correlation between current labor market conditions (as measured by labor market tightness or the job-finding rate) and future bond excess returns. We provide evidence for these predictions.

JEL classification: E24, E43, E44, G12, J64

Key words: interest rates, nondiversifiable labor income risk, labor market frictions, bond risk premia

The authors thank Jack Bao, George Constantinides, Andres Donangelo, Jack Favilukis, Mike Gallmeyer (discussant), Shiyang Huang, Mete Kilic (discussant), Leonid Kogan, Yang Liu, Yukun Liu (discussant), Sydney Ludvigson, Andrey Malenko, Thomas Maurer, Jianjun Miao, Francisco Palomino, Andres Schneider (discussant), Andrea Tamoni, and Haoxiang Zhu. They also thank seminar participants at the American Finance Assocation (scheduled), Academy of Financial Research Summer Institute, Atlanta Fed, BI Annual Workshop on Investment and Production-Based Asset Pricing (scheduled), City University of Hong Kong, Cornell University, European Economic Association-ESEM, European Finance Association, Federal Reserve Board, Florida State University, Labor and Finance Group, MFA, North American Summer Meeting of the Econometric Society, New York Fed, NFA, Office of Financial Research, Pennsylvania State University, Temple University, Texas A&M University, University of Delaware, University of Georgia, University of Hong Kong, University of Houston, University of Maryland, University of Michigan, University of Rochester, and the Western Finance Association for helpful comments and discussions. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Indrajit Mitra, Federal Reserve Bank of Atlanta, 1000 Peachtree St. NE, Atlanta, GA 30309, or Yu Xu, Lerner College of Business and Economics, University of Delaware.

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