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

  • Daniela Osterrieder

    ()

    (Aarhus University and CREATES)

  • Peter C. Schotman

    ()

    (Maastricht University)

Registered author(s):

    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.

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    File URL: ftp://ftp.econ.au.dk/creates/rp/12/rp12_35.pdf
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    Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2012-35.

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    Length: 51
    Date of creation: 03 Aug 2012
    Date of revision:
    Handle: RePEc:aah:create:2012-35
    Contact details of provider: Web page: http://www.econ.au.dk/afn/

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