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The Term Structure of the Risk-Return Tradeoff

  • Campbell, John Y
  • Viceira, Luis M

Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. In this paper we propose an empirical model that is able to capture these complex dynamics, yet is simple to apply in practice, and we explore its implications for asset allocation. Changes in investment opportunities can alter the risk-return tradeoff of bonds, stocks, and cash across investment horizons, thus creating a ‘term structure of the risk-return tradeoff’. We show how to extract this term structure from our parsimonious model of return dynamics, and illustrate our approach using data from the US stock and bond markets. We find that asset return predictability has important effects on the variance and correlation structure of returns on stocks, bonds and T-bills across investment horizons.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4914.

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Date of creation: Feb 2005
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Handle: RePEc:cpr:ceprdp:4914
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  1. Campbell, John & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Scholarly Articles 3122601, Harvard University Department of Economics.
  2. Campbell, John Y & Chan, Yeung Lewis & Viceira, Luis M, 2001. "A Multivariate Model of Strategic Asset Allocation," CEPR Discussion Papers 3070, C.E.P.R. Discussion Papers.
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  5. Campbell, John, 1991. "A Variance Decomposition for Stock Returns," Scholarly Articles 3207695, Harvard University Department of Economics.
  6. Campbell, John Y., 2001. "Why long horizons? A study of power against persistent alternatives," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 459-491, December.
  7. Harvey, Campbell R., 1989. "Time-varying conditional covariances in tests of asset pricing models," Journal of Financial Economics, Elsevier, vol. 24(2), pages 289-317.
  8. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
  9. Campbell, John & Viceira, Luis, 1999. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," Scholarly Articles 3163266, Harvard University Department of Economics.
  10. Goetzmann, W.N., 1990. "Testing The Predictive Power Of Dividend Yields," Papers fb-_90-12, Columbia - Graduate School of Business.
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  12. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, December.
  13. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Inflation Illusion and Stock Prices," NBER Working Papers 10263, National Bureau of Economic Research, Inc.
  14. repec:cup:etheor:v:11:y:1995:i:5:p:1131-47 is not listed on IDEAS
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  16. Cavanagh, Christopher L. & Elliott, Graham & Stock, James H., 1995. "Inference in Models with Nearly Integrated Regressors," Econometric Theory, Cambridge University Press, vol. 11(05), pages 1131-1147, October.
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  19. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  20. Geert Bekaert & Robert J. Hodrick & David Marshall, 1996. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Working Paper Series, Issues in Financial Regulation WP-96-3, Federal Reserve Bank of Chicago.
  21. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  22. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-61, June.
  23. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  24. Engle, Robert, 2002. "Dynamic Conditional Correlation: A Simple Class of Multivariate Generalized Autoregressive Conditional Heteroskedasticity Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 339-50, July.
  25. John Y. Campbell, 1985. "Stock Returns and the Term Structure," NBER Working Papers 1626, National Bureau of Economic Research, Inc.
  26. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  27. Fama, Eugene F., 1984. "The information in the term structure," Journal of Financial Economics, Elsevier, vol. 13(4), pages 509-528, December.
  28. Nicholas Barberis, 2000. "Investing for the Long Run when Returns Are Predictable," Journal of Finance, American Finance Association, vol. 55(1), pages 225-264, 02.
  29. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  30. Roberto Rigobon & Brian Sack, 2003. "Spillovers Across U.S. Financial Markets," NBER Working Papers 9640, National Bureau of Economic Research, Inc.
  31. Avramov, Doron, 2002. "Stock return predictability and model uncertainty," Journal of Financial Economics, Elsevier, vol. 64(3), pages 423-458, June.
  32. Graham Elliott & James H. Stock, 1992. "Inference in Time Series Regression When the Order of Integration of a Regressor is Unknown," NBER Technical Working Papers 0122, National Bureau of Economic Research, Inc.
  33. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  34. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
  35. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Cowles Foundation Discussion Papers 667, Cowles Foundation for Research in Economics, Yale University.
  36. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  37. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  38. Harvey, Campbell R, 1991. " The World Price of Covariance Risk," Journal of Finance, American Finance Association, vol. 46(1), pages 111-57, March.
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