Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors
NBER Working Paper No. 10086
We consider the consumption and portfolio choice problem of a long-run investor when the term structure is affine and when the investor has access to nominal bonds and a stock portfolio. In the presence of unhedgeable inflation risk, there exist multiple pricing kernels that produce the same bond prices, but a unique pricing kernel equal to the marginal utility of the investor. We apply our method to a three-factor Gaussian model with a time-varying price of risk that captures the failure of the expectations hypothesis seen in the data. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio for the long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, the desire to hedge changes in term premia generates large hedging demands for long-term bonds.
Published: Sangvinatsos, Antonios and Jessica A. Wachter. "Does The Failure Of The Expectations Hypothesis Matter For Long-Term Investors?," Journal of Finance, 2005, v60(1,Feb), 179-230.
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