Bond Risk Premia

Paper Session

Sunday, Jan. 8, 2017 1:00 PM – 3:00 PM

Sheraton Grand Chicago, Sheraton Ballroom III
Hosted By: American Finance Association
  • Chair: Carolin Pflueger, University of British Columbia

Robust Bond Risk Premia

Michael Bauer
,
Federal Reserve Bank of San Francisco
James D. Hamilton
,
University of California-San Diego

Abstract

A consensus has recently emerged that variables beyond the level, slope, and curvature of the yield curve can help predict bond returns. This paper shows that the statistical tests underlying this evidence are subject to serious small-sample distortions. We propose more robust tests, including a novel bootstrap procedure specifically designed to test the "spanning hypothesis." We revisit the evidence in five published studies, find most rejections of the spanning hypothesis to be spurious, and conclude that the current consensus is wrong. Only the level and the slope of the yield curve are robust predictors of bond returns.

Term Structure of Interest Rates With Short-Run and Long-Run Risks

Olesya Grishchenko
,
Federal Reserve Board
Zhaogang Song
,
Johns Hopkins University
Hao Zhou
,
Tsinghua University

Abstract

Bond returns are time-varying and predictable. What economic forces drive this variation? To answer this long-standing question, we propose a consumption-based model with recursive preferences, long-run risks, and inflation non-neutrality. Our model offers two important insights. First, our model matches well the upward-sloping nominal Treasury yield curve. Second, consistent with our model's implication, bond variance risk premium based on the interest rate derivatives data emerges as a strong predictor for short-horizon Treasury excess returns, above and beyond the predictive power of other popular factors. In the model equilibrium, the variance risk premium is related to the short-run risks in the economy, while standard forward-rate-based factors are associated with long-run risks in the economy.

Expected Term Structures

Andrea Buraschi
,
Imperial College London
Ilaria Piatti
,
University of Oxford
Paul Whelan
,
Copenhagen Business School

Abstract

This paper studies the properties of bond risk premia in the cross-section of subjective expectations. We exploit an extensive dataset of yield curve forecasts from financial institutions and document a number of novel findings. First, contrary to evidence presented for stock markets but consistent with rational expectations, the relation between subjective expectations and future realisations is positive, and this result holds for the entire cross-section of beliefs. Second, when predicting short term interest rates, primary dealers display superior forecasting ability when compared to non-primary dealers. Third, we reject the null hypothesis that subjective expected bond returns are constant. When predicting long term rates, however, primary dealers have no in- formation advantage. This suggests that a key source of variation in long-term bonds are risk premia and not short-term rate variation. Fourth, we show that consensus beliefs are not a sufficient statistics to describe the cross-section of beliefs. Moreover, the beliefs of the most accurate agents are those most spanned by a contemporaneous cross-section of bond prices. This supports equilibrium models and Friedman’s market selection hypothesis. Finally, we use ex-ante spanned subjective beliefs to study predictions of several reduced-form and structural models and uncover a number of statistically significant relationships in favour of rational expectations.
Discussant(s)
Jing Cynthia Wu
,
University of Chicago
Philippe Mueller
,
London School of Economics and Political Science
Christian Heyerdahl-Larsen
,
London Business School
JEL Classifications
  • G1 - Asset Markets and Pricing