Bond Risk Premia and Realized Jump Risk

Abstract:     
We find that augmenting a regression of excess bond returns on the term structure of forward rates with an estimate of the mean realized jump size almost doubles the R2 of the forecasting regression. The return predictability from augmenting with the jump mean easily dominates that offered by augmenting with options-implied volatility and realized volatility from high frequency data. In out-of-sample forecasting exercises, inclusion of the jump mean can reduce the root mean square prediction error by up to 40 percent. The incremental return predictability captured by the realized jump mean largely accounts for the countercyclical movements in bond risk premia. This result is consistent with the setting of an incomplete market in which the conditional distribution of excess bond returns is affected by a jump risk factor that does not lie in the span of the term structure of yields.

Number of Pages in PDF File: 33

Keywords: Unspanned Stochastic Volatility, Regime-Shift Term Structure, Bond Return Predictability, Expectations Hypothesis, Countercyclical Risk Premia, Realized Jump Risk

JEL Classification: G12, G14, E43, C22

Accepted Paper Series