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Understanding bond risk premia

  • Pavol Povala

    (University of Lugano)

  • Anna Cieslak

    (Northwestern University)

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    We decompose yields into long-horizon expected inflation and maturity-related cycles to study the predictability of bond excess returns. Cycles capture the risk premium and the business cycle variation of short rate expectations. From cycles, we construct a forecasting factor that explains up to above 50% (30%) of in-sample (out-of-sample) variation of annual bond returns. The factor varies at a frequency higher than the business cycle, and predicts real activity at long horizons. It also aggregates information from different macro-finance predictors of bond returns. Our decomposition reveals why bond returns are predictable by a linear combination of forward rates or the term spread.

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    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 771.

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    Date of creation: 2012
    Date of revision:
    Handle: RePEc:red:sed012:771
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    Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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    1. Todd E. Clark & Michael W. McCracken, 1999. "Tests of equal forecast accuracy and encompassing for nested models," Research Working Paper 99-11, Federal Reserve Bank of Kansas City.
    2. Hans DEWACHTER & Leonardo IANIA, 2009. "An extended macro-finance model with financial factors," Working Papers Department of Economics ces09.19, KU Leuven, Faculty of Economics and Business, Department of Economics.
    3. Amit Goval & Ivo Welch, 2004. "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," NBER Working Papers 10483, National Bureau of Economic Research, Inc.
    4. Jardet, C. & Monfort, A. & Pegoraro, F., 2009. "No-arbitrage Near-Cointegrated VAR(p) Term Structure Models, Term Premia and GDP Growth," Working papers 234, Banque de France.
    5. Jean-Sébastien Fontaine & René Garcia, 2009. "Bond Liquidity Premia," Staff Working Papers 09-28, Bank of Canada.
    6. Chryssi Giannitsarou & Eva Carceles-Poveda, 2004. "Adaptive Learning in Practice," Computing in Economics and Finance 2004 271, Society for Computational Economics.
    7. Dean Croushore & Tom Stark, 1999. "A real-time data set for macroeconomists," Working Papers 99-4, Federal Reserve Bank of Philadelphia.
    8. William J. Crowder & Mark E. Wohar, 1999. "Are Tax Effects Important in the Long-Run Fisher Relationship? Evidence from the Municipal Bond Market," Journal of Finance, American Finance Association, vol. 54(1), pages 307-317, 02.
    9. John A. Carlson, 1977. "A Study of Price Forecasts," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 6, number 1, pages 27-56 National Bureau of Economic Research, Inc.
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