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A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets
TL;DR: In this article, the authors develop and estimate a long-run risks model with time-varying volatilities of expected growth and inflation, which simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets.
Abstract: We show that bond risk-premia rise with uncertainty about expected inflation and fall with uncertainty about expected growth; the magnitude of return predictability using these two uncertainty measures is similar to that by multiple yields. Motivated by this evidence, we develop and estimate a long-run risks model with time-varying volatilities of expected growth and inflation. The model simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets. We find that preference for early resolution of uncertainty, time-varying volatilities, and non-neutral effects of inflation on growth are important to account for these aspects of asset markets.
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TL;DR: This article quantified how variation in real economic activity and ination in the U.S. Treasury market inuenced the market prices of level, slope, and curvature risks.
Abstract: This paper quanties how variation in real economic activity and ination in the U.S. inuenced the market prices of level, slope, and curvature risks in U.S. Treasury markets. To accomplish this we develop a novel arbitrage-free DTSM in which macroeconomic risks{ in particular, real output and ination risks{ impact bond investment decisions separately from information about the shape of the yield curve. Estimates of our preferred macro-DTSM over the twenty-three year period from 1985 through 2007 reveal that unspanned macro risks explained a substantial proportion of the variation in forward terms premiums. Unspanned macro risks accounted for nearly 90% of the conditional variation in short-dated forward term premiums, with unspanned real economic growth being the key driving factor. Over horizons beyond three years, these eects were entirely attributable to unspanned ination. Using our model, we also reassess some of Chairman Bernanke’s remarks on the interplay between term premiums, the shape of the yield curve, and macroeconomic activity.
505 citations
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TL;DR: The authors provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance, and shows that many features of the configuration of interest rate are puzzling from the perspective of the expectations hypothesis.
Abstract: This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from longer-term interest rates, and take actions to influence those rates. The simplest model of the term structure is the expectations hypothesis, which posits that long-term interest rates are expectations of future aver- age short-term rates. In this paper, we show that many features of the configuration of interest rates are puzzling from the perspective of the expectations hypothesis. We review models that explain these anomalies using time-varying risk premia. Although the quest for the fundamental macroeconomic explanations of these risk premia is ongoing, inflation uncertainty seems to play a large role. Finally, while modern finance theory prices bonds and other assets in a single unified framework, we also consider an earlier approach based on segmented markets. Market segmentation seems important to understand the term structure of interest rates during the recent financial crisis. ( JEL E31, E43, E52, E58)
290 citations
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TL;DR: In this paper, the authors compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems, but due to violations of uncovered interest rate parity in G10 currencies.
Abstract: Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies deliver significant excess returns with annualized Sharpe equal to or greater than those of equity market factors (1990-2012). Using data on out-of-the-money foreign exchange options, I compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems. A comparison of the returns to hedged and unhedged trades indicates crash risk premia account for at most one-third of the excess return to currency carry trades.
266 citations
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TL;DR: The authors surveys recent theoretical and empirical contributions on foreign exchange rate determination, and examines monetary models under uncovered interest parity and rational expectations and then considers deviations from UIP/rational expectations: foreign exchange risk premium, private information, near-rational expectations, and peso problems.
Abstract: This chapter surveys recent theoretical and empirical contributions on foreign exchange rate determination. The chapter first examines monetary models under uncovered interest parity and rational expectations, and then considers deviations from UIP/rational expectations: foreign exchange risk premium, private information, near-rational expectations, and peso problems.
239 citations
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TL;DR: The uncovered interest parity puzzle as mentioned in this paper concerns the empirical regularity that high interest rate countries tend to have high expected returns on short term deposits, and a separate puzzle is that high real interest rate country tends to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovering interest parity, which has apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials.
Abstract: The uncovered interest parity puzzle concerns the empirical regularity that high interest rate countries tend to have high expected returns on short term deposits. A separate puzzle is that high real interest rate countries tend to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two findings have apparently contradictory implications for the relationship of the foreign-exchange risk premium and interest-rate differentials. We document these puzzles, and show that existing models appear unable to account for both. A model that might reconcile the findings is discussed. (JEL E43, F31, G15)
234 citations
References
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TL;DR: This paper showed that an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
6,141 citations
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TL;DR: In this paper, a class of recursive, but not necessarily expected utility, preferences over intertemporal consumption lotteries is developed, which allows risk attitudes to be disentangled from the degree of inter-temporal substitutability, leading to a model of asset returns in which appropriate versions of both the atemporal CAPM and the inter-time consumption-CAPM are nested as special cases.
Abstract: This paper develops a class of recursive, but not necessarily expected utility, preferences over intertemporal consumption lotteries An important feature of these general preferences is that they permit risk attitudes to be disentangled from the degree of intertemporal substitutability Moreover, in an infinite horizon, representative agent context these preference specifications lead to a model of asset returns in which appropriate versions of both the atemporal CAPM and the intertemporal consumption-CAPM are nested as special cases In our general model, systematic risk of an asset is determined by covariance with both the return to the market portfolio and consumption growth, while in each of the existing models only one of these factors plays a role This result is achieved despite the homotheticity of preferences and the separability of consumption and portfolio decisions Two other auxiliary analytical contributions which are of independent interest are the proofs of (i) the existence of recursive intertemporal utility functions, and (ii) the existence of optima to corresponding optimization problems In proving (i), it is necessary to define a suitable domain for utility functions This is achieved by extending the formulation of the space of temporal lotteries in Kreps and Porteus (1978) to an infinite horizon framework A final contribution is the integration into a temporal setting of a broad class of atemporal non-expected utility theories For homogeneous members of the class due to Chew (1985) and Dekel (1986), the corresponding intertemporal asset pricing model is derived
4,218 citations
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TL;DR: In this paper, a consumption-based model is proposed to explain a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long-term horizon predictability of excess stock returns, and the countercyclical variations of stock market volatility.
Abstract: We present a consumption†based model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long†horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much of the history of stock prices from consumption data. It explains the short†and long†run equity premium puzzles despite a low and constant risk†free rate. The results are essentially the same whether we model stocks as a claim to the consumption stream or as a claim to volatile dividends poorly corelated with consumption. The model is driven by an independently and identically distributed consumption growth process and adds a slow †moving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia. Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of long†run average consumption growth.
3,886 citations
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TL;DR: In this article, the authors show that news about growth rates significantly alter agent's perceptions regarding long run expected growth rates and growth rate uncertainty, which leads to a large equity risk premium, low risk free interest rate, and large market volatility.
Abstract: We model dividend and consumption growth rates as containing a small long-run predictable component and economic uncertainty (i.e., growth rate volatility) as being time-varying. The magnitudes of the predictable variation and changing volatility in growth rates, as in the data, are quite small. These growth rate dynamics, for which we provide empirical support, in conjunction with plausible parameter configurations of the Epstein and Zin (1989) preferences can explain key observed asset markets phenomena. In particular, we show that the model can justify the observed equity premium, the low risk free rate, and the ex-post volatilities of the market return, real risk free rate, and the price-dividend ratio. As in the data, the model also implies that dividend yields predict returns and that market return volatility is stochastic. The main economic insight we capture is that news about growth rates significantly alter agent's perceptions regarding long run expected growth rates and growth rate uncertainty--in equilibrium, this leads to a large equity risk premium, low risk free interest rate, and large market volatility.
2,852 citations
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TL;DR: In this paper, the authors find that most of the variation in forward rates is variation in premium, and the premium and expected future spot rate components of forward rates are negatively correlated, and they conclude that the forward market is not efficient or rational.
2,217 citations