Risk and Return Trade-Off in the U.S. Treasury Market
University of North Carolina Kenan-Flagler Business School; University of North Carolina (UNC) at Chapel Hill - Department of Economics
University of North Carolina Kenan-Flagler Business School
University of North Carolina (UNC) at Chapel Hill - Kenan-Flagler Business School
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
March 1, 2014
This paper characterizes the risk-return trade-off in the U.S. Treasury market. We propose a discrete-time no-arbitrage term structure model, in which bond prices are solved in closed form and the conditional variances of bond yields are decomposed into a short-run component and a long-run component, each of which follows a GARCH-type process. Estimated using Treasury yields data from January 1962 to August 2007, our model simultaneously matches the conditional volatility dynamics and the deviation from the expectations hypothesis in the data. We find that a higher short-run volatility component of bond yields significantly predicts a higher future excess return, above and beyond the predictive power of the yields. The long-run volatility component does not predict bond excess returns.
Number of Pages in PDF File: 41
Keywords: bond risk premium, stochastic volatility, term structure models
JEL Classification: G12, C58
Date posted: March 3, 2014
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