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Long Forward Probabilities, Recovery, and the Term Structure of Bond Risk Premiums

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  • Likuan Qin
  • Vadim Linetsky
  • Yutian Nie

Abstract

This paper examines the assumption of transition independence of the stochastic discount factor (SDF) in the bond market. This assumption underlies the recovery result of Ross 2015. Following the methodology of Alvarez and Jermann 2005 and Hansen and Scheinkman 2009, we estimate the martingale component in the long-term factorization of the SDF using U.S. Treasury data. The empirically estimated martingale component is highly volatile and produces a downward-sloping term structure of bond Sharpe ratios. In contrast, the transition independence assumption implies a degenerate martingale component and an upward-sloping term structure of bond Sharpe ratios. Thus, transition independence is inconsistent with our empirical results. Received April 17, 2016; editorial decision January 17, 2018 by Editor Stijn Van Nieuwerburgh.

Suggested Citation

  • Likuan Qin & Vadim Linetsky & Yutian Nie, 2018. "Long Forward Probabilities, Recovery, and the Term Structure of Bond Risk Premiums," The Review of Financial Studies, Society for Financial Studies, vol. 31(12), pages 4863-4883.
    • Handle: RePEc:oup:rfinst:v:31:y:2018:i:12:p:4863-4883.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhy042
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    Cited by:

    1. Damir Filipovic & Martin Larsson & Anders B. Trolle, 2018. "On the Relation Between Linearity-Generating Processes and Linear-Rational Models," Papers 1806.03153, arXiv.org.
    2. Jackwerth, Jens Carsten & Menner, Marco, 2020. "Does the Ross recovery theorem work empirically?," Journal of Financial Economics, Elsevier, vol. 137(3), pages 723-739.
    3. Likuan Qin & Vadim Linetsky, 2018. "Long-term factorization in Heath–Jarrow–Morton models," Finance and Stochastics, Springer, vol. 22(3), pages 621-641, July.
    4. Svetlana Boyarchenko & Sergei Levendorskiu{i}, 2019. "Gauge transformations in the dual space, and pricing and estimation in the long run in affine jump-diffusion models," Papers 1912.06948, arXiv.org, revised Dec 2019.

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