An Interpretation of the Cieslak-Povala Return-Predicting Factor
12 Pages Posted: 5 Jul 2015
Date Written: July 3, 2015
This paper presents a simple reformulation of the restricted Cieslak and Povala (2010) return-predicting factor which retains by construction exactly the same (impressive) explanatory power as the original one, but affords an alternative and attractive interpretation. What determines the future returns, the new factor shows, is a function of the distance of the yield-curve level and the slope not from a fixed reference level, but from a conditional one, determined by a function of the long-term inflation.
The decomposition also allows a clear attribution of the predictive power of the Cieslak and Povala factor between the conditional level and slope deviations.
Finally, the new reformulation shows that once the conditionality is taken into account, level deviations are important predictors of excess returns. (Hardly any predictability was found in earlier studies for the unconditional level.)
Keywords: bond excess return, Cochrane and Piazzesi tent factor, return predicting factor, bond pricing
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