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

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  • Antonios Sangvinatsos
  • Jessica A. Wachter

Abstract

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.

Suggested Citation

  • Antonios Sangvinatsos & Jessica A. Wachter, 2003. "Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors," NBER Working Papers 10086, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10086
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    JEL classification:

    • G1 - Financial Economics - - General Financial Markets

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