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Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors

  • Antonios Sangvinatsos
  • Jessica A. Wachter

We consider the consumption and portfolio choice problem of a long-run investor when the term structure is affine and when the investor has access to nominal bonds and a stock portfolio. In the presence of unhedgeable inflation risk, there exist multiple pricing kernels that produce the same bond prices, but a unique pricing kernel equal to the marginal utility of the investor. We apply our method to a three-factor Gaussian model with a time-varying price of risk that captures the failure of the expectations hypothesis seen in the data. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio for the long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, the desire to hedge changes in term premia generates large hedging demands for long-term bonds.

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File URL: http://www.nber.org/papers/w10086.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10086.

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Date of creation: Nov 2003
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Publication status: published as Sangvinatsos, Antonios and Jessica A. Wachter. "Does The Failure Of The Expectations Hypothesis Matter For Long-Term Investors?," Journal of Finance, 2005, v60(1,Feb), 179-230.
Handle: RePEc:nbr:nberwo:10086
Note: AP
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  1. John Y. Campbell & Luis M. Viceira, 1998. "Who Should Buy Long-Term Bonds?," NBER Working Papers 6801, National Bureau of Economic Research, Inc.
  2. Campbell, John & Viceira, Luis, 1999. "Consumption and Portfolio Decisions When Expected Returns are Time Varying," Scholarly Articles 3163266, Harvard University Department of Economics.
  3. Chan, Yeung Lewis & Viceira, Luis & Campbell, John, 2003. "A Multivariate Model of Strategic Asset Allocation," Scholarly Articles 3163263, Harvard University Department of Economics.
  4. Campbell, John, 1986. "A Defense of Traditional Hypotheses about the Term Structure of Interest Rates," Scholarly Articles 3207698, Harvard University Department of Economics.
  5. 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.
  6. Andrew Ang & Geert Bekaert & Min Wei, 2008. "The Term Structure of Real Rates and Expected Inflation," Journal of Finance, American Finance Association, vol. 63(2), pages 797-849, 04.
  7. Wachter, Jessica A., 2003. "Risk aversion and allocation to long-term bonds," Journal of Economic Theory, Elsevier, vol. 112(2), pages 325-333, October.
  8. Yacine AÏT-SAHALIA, & Michael W. BRANDT, 2001. "Variable Selection for Portfolio Choice," FAME Research Paper Series rp34, International Center for Financial Asset Management and Engineering.
  9. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March.
  10. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  11. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  12. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April.
  13. 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.
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