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Arbitrage-free models of stocks and bonds
A small but ambitious literature uses affine arbitrage-free models to estimate jointly U.S. Treasury term premiums and the term structure of equity risk premiums. Within this approach, this paper identifies the parameter restrictions that are consistent with a simple dividend discount model, extends the cross-section to Germany and France, averages across multiple observable-factor and market prices of risk specifications, and considers alternative samples for parameter estimation. The results produce intuitive trajectories for both sets of premiums given standard samples starting from July ...
Working Paper
An estimate of the inflation risk premium using a three-factor affine term structure model
This paper decomposes nominal Treasury yields into expected real rates, expected inflation rates, real risk premiums, and inflation risk premiums by separately calibrating a three-factor affine term structure model to the nominal Treasury and TIPS yield curves. Although this particular application seems to produce expected real short rates and inflation rates that are somewhat static, there are theoretical advantages to calibrating the model to nominal and real yields separately. Moreover, the estimates correlate positively with back-of-the-envelope measures of the inflation risk premium. ...
Working Paper
The extreme bounds of the cross-section of expected stock returns
Several empirical studies report violations of the asset-pricing model of Sharpe (1964), Lintner (1965), and Black (1972). But, there is no consensus on specification in this literature, as such studies typically consider only a limited number of explanatory variables and do not satisfactorily control for previous findings. Extreme bound analysis (EBA), an imperfect but useful remedy for model uncertainty, suggests that comparatively few factors are robust. Given the cross-section of expected stock returns from July 1963 through December 2000, three of 23 variables - market size as well as ...
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Momentum and the term structure of interest rates
A vast literature reports excess returns to momentum strategies across many financial asset classes. However, no study examines trading rules based on price history along individual government-bond term structures?that is, with respect to duration buckets across the curve?as opposed to across sovereign markets or individual term structures as a whole over time. Under duration-neutral and long-only constraints as well as low trading costs, this paper reports excess annualized returns of up to 120 basis points and information ratios as high as 0.79 using U.S. Treasury total return data from ...
Working Paper
Foreign portfolio investment, foreign bank lending, and economic growth
In contrast to the empirical literature's focus on foreign direct investment (FDI), this study examines the effects of foreign portfolio investment (FPI) and "other" foreign investment (OFI) on economic growth using data on 88 countries from 1977 through 2000. Most measures suggest that FPI has no effect, and some results indicate that OFI has a negative impact on growth that is somewhat mitigated by initial financial and/or legal development. However, these results are questionable due to possible simultaneity bias. The empirical analyses also examine whether non-FDI foreign investment ...
Working Paper
Jump-diffusion processes and affine term structure models: additional closed-form approximate solutions, distributional assumptions for jumps, and parameter estimates
Affine term structure models in which the short rate follows a jump-diffusion process are difficult to solve, and the parameters of such models are hard to estimate. Without analytical answers to the partial difference differential equation (PDDE) for bond prices implied by jump-diffusion processes, one must find a numerical solution to the PDDE or exactly solve an approximate PDDE. Although the literature focuses on a single linearization technique to estimate the PDDE, this paper outlines alternative methods that seem to improve accuracy. Also, closed-form solutions, numerical estimates, ...
Working Paper
Estimates of the term premium on near-dated federal funds futures contracts
This paper examines estimates of the term premium on federal funds futures rates, with a focus on near-dated contracts and therefore the more immediate policy horizon. The first set of methods assumes that the term premium is constant over time. Under this framework, calculations that use survey data to proxy for forecast errors produce more intuitive results than estimates based on the restrictive assumption that forecast errors average to zero over the sample. The second set of methods allows the term premium to vary over time, but the results based on the term structure of near-dated ...
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Betting against beta (and gamma) using government bonds
Purportedly consistent with ?risk parity? (RP) asset allocation, recent studies document compelling ?low risk? trading strategies that exploit a persistently negative relation between Sharpe ratios (SRs) and maturity along the U.S. Treasury (UST) term structure. This paper extends this evidence on betting against beta with government bonds (BABgov) in four respects. First, out-of-sample tests suggest that excess returns may have waned somewhat recently and that the pattern seems most pronounced for USTs given data on ten other previously unexamined government bond markets. Second, BABgov ...
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More on U.S. Treasury term premiums: spot and expected measures
Several studies that use affine term structure models (ATSMs) or survey data suggest that subdued nominal U.S. Treasury yields during the global financial crisis and its aftermath primarily reflected exceptionally low, if not negative, term premiums as distinct from depressed anticipated short rates. However, this literature pays little attention to the length of time market participants anticipated low term premiums to prevail, as captured by the ?forward? or ?expected? term premium over a given horizon, distinct from the ?spot? term premium. Besides the implications for investors at the ...
Working Paper
Implied interest rate skew, term premiums, and the \"conundrum\"
The skew, irrespective of the mean and variance, of investors' interest rate expectations may affect required bond yields over expected short rates. Indeed, evidence suggests that the near-term skew of the option-implied distribution of expected short-term interest rates correlates with distant-horizon term premiums, as derived from a latent-factor affine term structure model (ATSM). Reduced-form models that include skew generally fit the data well and actually better "explain" variation in the term premium during the so-called "conundrum" than during other periods of the May 1989 to May ...