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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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    File URL: https://www.economicdynamics.org/meetpapers/2012/paper_771.pdf
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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
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    Handle: RePEc:red:sed012:771
    Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
    Fax: 1-314-444-8731
    Web page: http://www.EconomicDynamics.org/society.htm
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