A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets
AbstractWe 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 two uncertainty measures is similar to that by multiple yields. Motivated by this evidence, we develop and estimate a long-run risks model with time-varying 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.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18357.
Date of creation: Sep 2012
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