NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets

Ravi Bansal, Ivan Shaliastovich

NBER Working Paper No. 18357
Issued in September 2012
NBER Program(s):   AP   IFM   ME

We show that bond risk-premia rise with uncertainty about expected inflation and fall with uncertainty about expected growth; the magnitude of return predictability using these two uncertainty measures is similar to that by multiple yields. Motivated by this evidence, we develop and estimate a long-run risks model with time-varying volatilities of expected growth and inflation. The model simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets. We find that preference for early resolution of uncertainty, time-varying volatilities, and non-neutral effects of inflation on growth are important to account for these aspects of asset markets.

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Document Object Identifier (DOI): 10.3386/w18357

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