The Layman's Summary of the Expected Bond Return Literature
35 Pages Posted: 13 Jan 2016 Last revised: 21 Jan 2016
Date Written: January 9, 2016
Expected returns are what we expect to earn over the next year if we choose to invest today. The expected return is not plucked out of thin air, but is modeled by our hero: The Econometrician. In scholastic seminars, he explains how to interpret expected bond returns, and in client emails, the intuition behind why he expects his models to work for the foreseeable future. He takes the time to review how to decompose expected returns into a real, inflation, liquidity and monetary policy risk premium. He is the hero because he is able to effectively communicate his ideas and expand his framework when new predictors emerge in the literature. Two such predictors include the banks’ income gap, put forth by Haddad and Srear (2015), and a related measure, mortgage duration as championed by Hanson (2014). He also finds ways to work in older ideas by establishing simple strategies to look at how other variables related to bond yields influence changes in the shape of the curve. The Econometrician embraces clarity and would argue that, despite its growing popularity among academetricians, the affine term structure model provides absolutely no gain in understanding the source of expected returns for common men.
Keywords: income gap, acm, mortgage duration, expected returns, treasury returns, yield curve, inflation risk premium, liquidity risk premium
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