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Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors?

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Author Info
ANTONIOS SANGVINATSOS
JESSICA A. WACHTER

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Abstract

We solve the portfolio problem of a long-run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock. We apply our method to a three-factor model that captures the failure of the expectations hypothesis. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio of a long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, time-varying term premia generate large hedging demands for long-term bonds. Copyright 2005 by The American Finance Association.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2005.00728.x
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Publisher Info
Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 60 (2005)
Issue (Month): 1 (02)
Pages: 179-230
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Handle: RePEc:bla:jfinan:v:60:y:2005:i:1:p:179-230

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Ait-Sahalia, Y. & Brandt, M.W., 2001. "Variable Selection for Portfolio Choice," Papers 34, Manitoba - Department of Economics.
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  2. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November. [Downloadable!] (restricted)
  3. Nicholas Barberis, 2000. "Investing for the Long Run when Returns Are Predictable," Journal of Finance, American Finance Association, vol. 55(1), pages 225-264, 02. [Downloadable!] (restricted)
  4. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April. [Downloadable!] (restricted)
  6. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March. [Downloadable!] (restricted)
  7. John Y. Campbell & Luis M. Viceira, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March. [Downloadable!] (restricted)
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  8. Campbell, John Y, 1986. " A Defense of Traditional Hypotheses about the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 41(1), pages 183-93, March. [Downloadable!] (restricted)
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  9. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March. [Downloadable!]
  10. Wachter, Jessica A., 2003. "Risk aversion and allocation to long-term bonds," Journal of Economic Theory, Elsevier, vol. 112(2), pages 325-333, October. [Downloadable!] (restricted)
  11. John Y. Campbell & Luis M. Viceira, 1998. "Consumption and Portfolio Decisions When Expected Returns Are Time Varying," Harvard Institute of Economic Research Working Papers 1835, Harvard - Institute of Economic Research.
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jules H. van Binsbergen & Michael W. Brandt, 2007. "Optimal Asset Allocation in Asset Liability Management," NBER Working Papers 12970, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Caio Ibsen R. Almeida & José Valentim M. Vicente, 2006. "Term Structure Movements Implicit in Option Prices," Working Papers Series 128, Central Bank of Brazil, Research Department. [Downloadable!]
  3. Frank de Jong, 2005. "Valuation of pension liabilities in incomplete markets," DNB Working Papers 067, Netherlands Central Bank, Research Department. [Downloadable!]
  4. Ralph S.J Koijen & Otto Van Hemert & Stijn Van Nieuwerburgh, 2007. "Mortgage Timing," NBER Working Papers 13361, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Sørensen, Carsten & Trolle, Anders Bjerre, 2006. "Dynamic asset allocation and latent variables," Working Papers 2004-8, Copenhagen Business School, Department of Finance. [Downloadable!]
  6. Koijen, Ralph S.J. & Nijman, Theo E. & Werker, Bas J.M., 2006. "Optimal portfolio choice with annuitization," Discussion Paper 78, Tilburg University, Center for Economic Research. [Downloadable!]
  7. Jules H. van Binsbergen & Michael W. Brandt & Ralph S.J. Koijen, 2006. "Optimal Decentralized Investment Management," NBER Working Papers 12144, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. Don Kim, 2008. "Challenges in macro-finance modeling," Finance and Economics Discussion Series 2008-06, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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