Conditional Time-Varying Interest Rate Risk Premium: Evidence from the Treasury Bill Futures Market

Existing studies of the term structure of interest rates often use spot Treasury rates to represent default-free interest rates. However, part of the premium in Treasury rates is compensation for the risk that short-sellers may default. Since Treasury bill futures are default-free, they provide cleaner data to estimate the interest rate risk premium. The mean excess return in defaultfree Treasury bill futures is zero. This suggests that the interest rate risk premium could be economically negligible. We find that although the mean unconditional premium is zero, futures returns contain economically and statistically significant time-varying conditional interest rate risk premiums. The conditional premium depends significantly positively on its own conditional variance and its conditional covariance with the equity premium. The conditional premium is large in the volatile 1979–82 period, but small afterwards.