I am reading about the Vasicek One Factor short rate model and how to implement a change in measure from a risk-neutral to real-world measure, when I came across this comment:

Adding a negative risk premium to the short rate will in principle avoid the occurrence of inverse yield curves.

Why would this be the case? What could be a possible intuitive interpretation or justification for this statement?

Thank you for your time in advance.

  • 1
    $\begingroup$ Long rates can be decomposed into expected short rates and a term premium (constant with Vasicek). The yield curve slope is low when short rates are expected to decline. But when term premium is sufficiently large the slope is still positive. $\endgroup$
    – fes
    May 26, 2021 at 18:14
  • $\begingroup$ Because the Term Premium is (usually) assumed to add to interest rates an amount proportional to the Maturity T (i.e. it is linear in maturity), it has a bigger effect at longer maturities. Thus contributing to creating a rising term structure. $\endgroup$
    – nbbo2
    May 26, 2021 at 22:04


Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.