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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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    Cited by:

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    2. Mirco Rubin & Dario Ruzzi, 2020. "Equity Tail Risk in the Treasury Bond Market," Papers 2007.05933, arXiv.org.
    3. Mirco Rubin & Dario Ruzzi, 2020. "Equity tail risk in the treasury bond market," Temi di discussione (Economic working papers) 1311, Bank of Italy, Economic Research and International Relations Area.

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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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