Back to the Real Economy: The Effects of Risk Mispricing on the Term Premium and Bank Lending

Bond markets can plummet or rally on the back of sentiment-driven reactions to news which are unrelated to fundamentals. Changes in bond prices can therefore not only be interpreted as reflecting risk but also mispricing of long-term assets. These perceived risks can often feed back into the economy by affecting the supply of credit. We construct a DSGE model with heterogeneous banks, and asset pricing rules that generate a time-varying term premium, and introduce bond risk mispricing shocks to study their effects on the real economy. A risk mispricing shock, in which agents overprice perceived risk, increases term premia and lowers output by reducing the availability of credit, as banks rebalance portfolios in favour of longer-term bonds. However, when investors underprice risk, a compressed term premium leads to a `bad' credit boom that results in a more severe recession once the snapback occurs

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