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Economic Quarterly

Fall 2006

Bond Price Premiums

Alexander L. Wolman

Nominal and real interest rates are often viewed from the perspectives of the intuitively appealing Fisher relationship and pure expectations hypothesis. These complementary relationships relate real or nominal long-term interest rates to expected future short-term interest rates and relate short- or long-term nominal interest rates to the ex ante real interest rate and the expected inflation rate. Consumption-based bond pricing theory implies that if investors are risk-averse then interest rates deviate from the Fisher relationship and the expectations hypothesis, and the deviations are described by forward premiums and inflation-risk premiums. We provide a detailed introduction to the theory, using the two Fisherian interest rate decompositions and the corresponding premiums as the organizing framework.

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