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Bond Risk Premia and Gaussian Term Structure Models

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  • Bruno Feunou
  • Jean-Sébastien Fontaine

Abstract

Cochrane and Piazzesi (2005) show that (i) lagged forward rates improve the predictability of annual bond returns, adding to current forward rates, and that (ii) a Markovian model for monthly forward rates cannot generate the pattern of predictability in annual returns. These results stand as a challenge to modern Markovian dynamic term structure models (DTSMs). We develop the family of conditional mean DTSMs where the yield dynamics depend on current yields and their history. Empirically, we find that (i) current and past yields generate cyclical risk-premium variations, (ii) the model risk premia offer better returns forecasts, and (iii) the model coefficients are close to Cochrane-Piazzesi regressions of long-horizon returns. Yield decompositions differ significantly from what a standard model suggests - the expectation component decreases less in a recession and increases less in the recovery. A small Markovian factor “hidden” in measurement error (Duffee, 2011) explains some of the differences but is not sufficient to match the evidence.

Suggested Citation

  • Bruno Feunou & Jean-Sébastien Fontaine, 2014. "Bond Risk Premia and Gaussian Term Structure Models," Staff Working Papers 14-13, Bank of Canada.
  • Handle: RePEc:bca:bocawp:14-13
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    References listed on IDEAS

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    3. Fama, Eugene F., 1984. "Term premiums in bond returns," Journal of Financial Economics, Elsevier, vol. 13(4), pages 529-546, December.
    4. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
    5. Sydney C. Ludvigson & Serena Ng, 2009. "Macro Factors in Bond Risk Premia," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5027-5067, December.
    6. Froot, Kenneth A, 1989. " New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(2), pages 283-305, June.
    7. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
    8. Andrew Ang & Sen Dong & Monika Piazzesi, 2005. "No-arbitrage Taylor rules," Proceedings, Federal Reserve Bank of San Francisco.
    9. Ravenna, Federico, 2007. "Vector autoregressions and reduced form representations of DSGE models," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2048-2064, October.
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    More about this item

    Keywords

    Asset Pricing; Interest rates;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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