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The Volatility of Long-term Bond Returns: Persistent Interest Shocks and Time-varying Risk Premiums

Author

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  • Daniela Osterrieder

    () (Aarhus University and CREATES)

  • Peter C. Schotman

    () (Maastricht University)

Abstract

We develop a model that can match two stylized facts of the term-structure. The first stylized fact is the predictability of excess returns on long-term bonds. Modeling this requires sufficient volatility and persistence in the price of risk. The second stylized fact is that long-term yields are dominated by a level factor, which requires persistence in the spot interest rate. We find that a fractionally integrated process for the short rate plus a fractionally integrated specification for the price of risk leads to an analytically tractable almost affine term structure model that can explain the stylized facts. In a decomposition of long-term bond returns we find that the expectations component from the level factor is more volatile than the returns themselves. It therefore takes a volatile risk premium that is negatively correlated with innovations in the level factor to explain the volatility of long-term bond returns. The model also implies that excess bond returns do not exhibit mean reversion, consistent with the empirical evidence.

Suggested Citation

  • Daniela Osterrieder & Peter C. Schotman, 2012. "The Volatility of Long-term Bond Returns: Persistent Interest Shocks and Time-varying Risk Premiums," CREATES Research Papers 2012-35, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2012-35
    as

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    File URL: ftp://ftp.econ.au.dk/creates/rp/12/rp12_35.pdf
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    References listed on IDEAS

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    Cited by:

    1. Carlo A. Favero & Arie E. Gozluklu & Haoxi Yang, 2016. "Demographics and the Behavior of Interest Rates," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 732-776, November.
    2. Håvard Hungnes, 2016. "Fractionality and co-fractionality between Government Bond yields," Discussion Papers 838, Statistics Norway, Research Department.

    More about this item

    Keywords

    term structure of interest rates; fractional integration; affine models.;

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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