Macro Factors in Bond Risk Premia
AbstractEmpirical evidence suggests that excess bond returns are forecastable by financial indicators such as forward spreads and yield spreads, a violation of the expectations hypothesis based on constant risk premia. But existing evidence does not tie the forecastable variation in excess bond returns to underlying macroeconomic fundamentals, as would be expected if the forecastability were attributable to time variation in risk premia. We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that several common factors estimated from a large dataset on U.S. economic activity have important forecasting power for future excess returns on U.S. government bonds. Following Cochrane and Piazzesi (2005), we also construct single predictor state variables by forming linear combinations of either five or six estimated common factors. The single state variables forecast excess bond returns at maturities from two to five years, and do so virtually as well as an unrestricted regression model that includes each common factor as a separate predictor variable. The linear combinations we form are driven by both "real" and "inflation" macro factors, in addition to financial factors, and contain important information about one year ahead excess bond returns that is not captured by forward spreads, yield spreads, or the principal components of the yield covariance matrix.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11703.
Date of creation: Oct 2005
Date of revision:
Publication status: published as Sydney C. Ludvigson & Serena Ng, 2009. "Macro Factors in Bond Risk Premia," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(12), pages 5027-5067, December.
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Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Web page: http://www.nber.org
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Other versions of this item:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- E0 - Macroeconomics and Monetary Economics - - General
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-11-05 (All new papers)
- NEP-FIN-2005-11-05 (Finance)
- NEP-FMK-2005-11-05 (Financial Markets)
- NEP-FOR-2005-11-05 (Forecasting)
- NEP-MAC-2005-11-05 (Macroeconomics)
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- Stock J.H. & Watson M.W., 2002. "Forecasting Using Principal Components From a Large Number of Predictors," Journal of the American Statistical Association, American Statistical Association, vol. 97, pages 1167-1179, December.
- James H. Stock & Mark W. Watson, 2005. "Implications of Dynamic Factor Models for VAR Analysis," NBER Working Papers 11467, National Bureau of Economic Research, Inc.
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