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Regime Shifts and Bond Returns

  • Jacob Boudoukh
  • Matthew Richardson
  • Tom Smith
  • Robert Whitelaw
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    This paper investigates the implications of a 2-regime model of the business cycle for term premiums and volatilities in the bond market. The model, which is estimated via maximum likelihood using GDP, consumption and production data, has two key features -- mean growth rates that vary across regimes and time-varying transition probabilities between regimes. The implied dynamics of term premiums and volatilities are complex and interesting. Business cycle turning points are characterized by high volatility and strongly time-varying term premiums. These implications are then investigated using data on bond returns. Nonparametric estimation results are broadly consistent with the model. Using the slope of the term structure as a conditioning variable, we can identify periods with negative term premiums and volatile returns.

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    File URL: http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99010.pdf
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    Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 99-010.

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    Date of creation: 01 Nov 1999
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    Handle: RePEc:fth:nystfi:99-010
    Contact details of provider: Postal: U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126
    Phone: (212) 998-0100
    Web page: http://w4.stern.nyu.edu/finance/

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    1. Diebold, Francis X & Rudebusch, Glenn D, 1996. "Measuring Business Cycles: A Modern Perspective," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 67-77, February.
    2. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
    3. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, vol. 80(3), pages 398-418, June.
    4. Filardo, Andrew J, 1994. "Business-Cycle Phases and Their Transitional Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 299-308, July.
    5. Chang-Jin Kim & Charles Nelson, 1999. "A Bayesian Approach to Testing for Markov Switching in Univariate and Dynamic Factor Models," Discussion Papers in Economics at the University of Washington 0035, Department of Economics at the University of Washington.
    6. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    7. Arthur F. Burns & Wesley C. Mitchell, 1946. "Measuring Business Cycles," NBER Books, National Bureau of Economic Research, Inc, number burn46-1, August.
    8. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
    9. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
    10. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
    11. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    12. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
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