Hansen-Jagannathan Bounds with Convenience Yields

Abstract

Short-term Treasury debt has high Sharpe ratios which, according to the Hansen-Jagannathan bound, implies a very volatile bond market SDF. In this paper, we show that a small convenience yield on the risk-free asset can rationalize this pattern without requiring a volatile SDF. We then show how the Hansen-Jagannathan bound needs to be generalized as a two-dimensional trade-off between SDF volatility and the convenience yield. We quantify this trade-off in the Treasury market, and show the introduction of convenience yields greatly improves the fit of affine term structure models.

Keywords: Bond Returns, convenience yields, sharpe ratios, Hansen-Jagannathan bound