The Term Premium in a Small Open Economy: A Micro-Founded Approach

We study the term premium on nominal and real government bonds in a small open economy within a micro-founded DSGE model with Epstein- Zin preferences. We solve the model using a third-order approximation to allow for time-varying risk premia. We thus extend previous work on closed economies to the case of a small open economy. We find that tech- nological spillovers from the global economy to the small open economy are essential for the ability of the model to produce concurrently a sub- stantial positive nominal term premium, realistic variability of the main macroeconomic variables, and high correlations between the global and domestic economies as evident in the data. We use the model to study the effect of the openness of the economy on bond risk premia. We identify two opposing effects of the openness of the economy on the nominal term premium. The better ability of the open economy to accommodate domes- tic shocks works to decrease the term premium in the open economy. By contrast, in the presence of technological spillovers from the global econ- omy to the small open economy, the foreign technological shock generates a higher term premium in the open economy compared to a closed one. Quantitatively, in our model these effects roughly offset each other so that the term premium in the open economy is similar to the premium in an otherwise similar economy that is closed to trade in goods and financial assets.