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A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets

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  • Ravi Bansal
  • Ivan Shaliastovich
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    Abstract

    We show that bond risk premia rise with uncertainty about expected inflation and fall with uncertainty about expected growth; the magnitude of return predictability using these uncertainty measures is similar to that by multiple yields. Motivated by this evidence, we develop and estimate a long-run risks model with timevarying volatilities of expected growth and inflation. The model simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets. We find that preference for early resolution of uncertainty, time-varying volatilities, and non-neutral effects of inflation on growth are important to account for these aspects of asset markets. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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    File URL: http://hdl.handle.net/10.1093/rfs/hhs108
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    Bibliographic Info

    Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

    Volume (Year): 26 (2013)
    Issue (Month): 1 ()
    Pages: 1-33

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    Handle: RePEc:oup:rfinst:v:26:y:2013:i:1:p:1-33

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    Cited by:
    1. John Y. Campbell & Carolin Pflueger & Luis M. Viceira, 2014. "Monetary Policy Drivers of Bond and Equity Risks," NBER Working Papers 20070, National Bureau of Economic Research, Inc.
    2. Du, Du, 2013. "General equilibrium pricing of currency and currency options," Journal of Financial Economics, Elsevier, vol. 110(3), pages 730-751.
    3. Carolin E. Pflueger & Luis M. Viceira, 2011. "Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity," NBER Working Papers 16892, National Bureau of Economic Research, Inc.
    4. Gildas Lamé, 2013. "Was there a "Greenspan conundrum" in the Euro Area ?," Working Papers 2013-07, Centre de Recherche en Economie et Statistique.
    5. Aysun, Uluc & Lee, Sanglim, 2014. "Can time-varying risk premiums explain the excess returns in the interest rate parity condition?," Emerging Markets Review, Elsevier, vol. 18(C), pages 78-100.
    6. A. Craig Burnside & Jeremy J. Graveline, 2012. "On the Asset Market View of Exchange Rates," NBER Working Papers 18646, National Bureau of Economic Research, Inc.
    7. Jerry Tsai, 2013. "Rare Disasters and the Term Structure of Interest Rates," Economics Series Working Papers 665, University of Oxford, Department of Economics.
    8. A. Craig Burnside & Jeremy J. Graveline, 2013. "Exchange Rate Determination, Risk Sharing and the Asset Market View," Working Papers 13-1, Duke University, Department of Economics.

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