Riding the Yield Curve: Risk Taking Behavior in a Low Interest Rate Environment

Investors seek to hedge against interest rate risk by taking long or short positions on bonds of different maturities. We study changes in risk taking behavior in a low interest rate environment by estimating a market stochastic discount factor that is non-linear and therefore consistent with the empirical properties of cashflow valuations identified in the literature. We provide evidence that non-linearities arise from hedging strategies of investors exposed to interest rate risk. Capital losses are amplified when interest rates increase and risk averse investors have taken positions on instruments with longer maturity, expecting instead interest rates to revert back to their historical average.