Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors

66 Pages Posted: 5 Nov 2008

See all articles by Antonios A. Sangvinatsos

Antonios A. Sangvinatsos

New York University (NYU) - Department of Finance; Marshall School of Business, USC

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2003

Abstract

We consider the consumption and portfolio choice problem of a long-run investor when the term structure is affine and when the investor has access to nominal bonds and a stock portfolio. In the presence of unhedgeable inflation risk, there exist multiple pricing kernels that produce the same bond prices, but a unique pricing kernel equal to the marginal utility of the investor. We apply our method to a three-factor Gaussian model with a time-varying price of risk that captures the failure of the expectations hypothesis seen in the data. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio for the long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, the desire to hedge changes in term premia generates large hedging demands for long-term bonds.

Suggested Citation

Sangvinatsos, Antonios A. and Wachter, Jessica A., Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors (December 2003). NYU Working Paper No. S-CDM-03-13, Available at SSRN: https://ssrn.com/abstract=1295795

Antonios A. Sangvinatsos (Contact Author)

New York University (NYU) - Department of Finance ( email )

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Marshall School of Business, USC ( email )

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HOME PAGE: http://www-rcf.usc.edu/~sangvina/

Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

The Wharton School
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215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

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