Long Forward Probabilities, Recovery and the Term Structure of Bond Risk Premiums

19 Pages Posted: 26 Jan 2016

See all articles by Likuan Qin

Likuan Qin

Northwestern University - Department of Industrial Engineering and Management Sciences

Vadim Linetsky

Northwestern University - Department of Industrial Engineering and Management Sciences

Yutian Nie

Quantitative Risk Management, Inc.

Date Written: January 24, 2016

Abstract

We show that the martingale component in the long-term factorization of the stochastic discount factor due to Alvarez and Jermann (2005) and Hansen and Scheinkman (2009) is highly volatile, produces a downward-sloping term structure of bond Sharpe ratios, and implies that the long bond is far from growth optimality. In contrast, the long forward probabilities forecast an upward sloping term structure of bond Sharpe ratios that starts from zero for short-term bonds and implies that the long bond is growth optimal. Thus, transition independence and degeneracy of the martingale component are implausible assumptions in the bond market.

Suggested Citation

Qin, Likuan and Linetsky, Vadim and Nie, Yutian, Long Forward Probabilities, Recovery and the Term Structure of Bond Risk Premiums (January 24, 2016). Available at SSRN: https://ssrn.com/abstract=2721366 or http://dx.doi.org/10.2139/ssrn.2721366

Likuan Qin (Contact Author)

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

Vadim Linetsky

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

Yutian Nie

Quantitative Risk Management, Inc. ( email )

181 W. Madison St
Chicago, IL 60602
United States

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