The Volatility of Long-Term Bond Returns: Persistent Interest Shocks and Time-Varying Risk Premiums

51 Pages Posted: 3 Aug 2012

See all articles by Daniela Osterrieder

Daniela Osterrieder

Rutgers Business School; CREATES

Peter C. Schotman

Maastricht University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: August 3, 2012

Abstract

We develop a model that can match two stylized facts of the term-structure. The first stylized fact is the predictability of excess returns on long-term bonds. Modeling this requires sufficient volatility and persistence in the price of risk. The second stylized fact is that long-term yields are dominated by a level factor, which requires persistence in the spot interest rate. We find that a fractionally integrated process for the short rate plus a fractionally integrated specification for the price of risk leads to an analytically tractable almost affine term structure model that can explain the stylized facts. In a decomposition of long-term bond returns we find that the expectations component from the level factor is more volatile than the returns themselves. It therefore takes a volatile risk premium that is negatively correlated with innovations in the level factor to explain the volatility of long-term bond returns. The model also implies that excess bond returns do not exhibit mean reversion, consistent with the empirical evidence.

Keywords: term structure of interest rates, fractional integration, affine models

JEL Classification: C58, G12, C32

Suggested Citation

Osterrieder, Daniela and Schotman, Peter C., The Volatility of Long-Term Bond Returns: Persistent Interest Shocks and Time-Varying Risk Premiums (August 3, 2012). Available at SSRN: https://ssrn.com/abstract=2123412 or http://dx.doi.org/10.2139/ssrn.2123412

Daniela Osterrieder

Rutgers Business School ( email )

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CREATES ( email )

Aarhus University
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Peter C. Schotman (Contact Author)

Maastricht University - Department of Finance ( email )

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Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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