Bond Risk Premia and Realized Jump Risk
Jonathan H. Wright
Board of Governors of the Federal Reserve System - Trade and Financial Studies Section
PBC School of Finance, Tsinghua University
April 15, 2009
Journal of Banking and Finance, Forthcoming
FEDS Working Paper No. 2007-22
AFA 2009 San Francisco Meetings Paper
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, C22Accepted Paper Series
Date posted: March 20, 2008 ; Last revised: July 27, 2009
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