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A note on the predictability of excess bond returns and regime shifts

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  • Zhu, Xiaoneng
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    Abstract

    This paper shows that the predictability of excess bond returns could be due to the persistence of regime shifts in interest rate dynamics. This is achieved through the introduction of a regime-dependent heteroscedasticity into the discrete Vasicek model. It therefore provides a new perspective on understanding the predictability of excess returns and the violation of the expectations hypothesis. The model implies that more uncertain the current regime is, more predictable excess returns are. The empirical analysis suggests that regime shifts have forecasting power beyond the predictive power contained in time-varying risk premiums and irrational expectations.

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    Bibliographic Info

    Article provided by Elsevier in its journal Finance Research Letters.

    Volume (Year): 8 (2011)
    Issue (Month): 2 (June)
    Pages: 101-109

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    Handle: RePEc:eee:finlet:v:8:y:2011:i:2:p:101-109

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    Web page: http://www.elsevier.com/locate/frl

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    Keywords: Excess returns Forward rates Predictability Regime shifts;

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    1. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
    2. Geert Bekaert, 2001. "Expectations Hypotheses Tests," Journal of Finance, American Finance Association, vol. 56(4), pages 1357-1394, 08.
    3. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
    4. John H. Cochrane & Monika Piazzesi, 2005. "Bond Risk Premia," American Economic Review, American Economic Association, vol. 95(1), pages 138-160, March.
    5. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
    6. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
    7. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    8. Ang, Andrew & Bekaert, Geert, 2002. "Regime Switches in Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 163-82, April.
    9. Monika Piazzesi & Martin Schneider, 2009. "Trend and cycle in bond premia," Staff Report 424, Federal Reserve Bank of Minneapolis.
    10. Sydney C. Ludvigson & Serena Ng, 2009. "Macro Factors in Bond Risk Premia," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5027-5067, December.
    11. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
    12. Ravi Bansal & Hao Zhou, 2001. "Term structure of interest rates with regime shifts," Finance and Economics Discussion Series 2001-46, Board of Governors of the Federal Reserve System (U.S.).
    13. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
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