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John H. Cochrane, Monika Piazzesi
NBER Working Paper No. 9178*
Issued in September 2002
NBER Program(s): AP
EFG
ME
---- Abstract -----
This paper studies time variation in expected excess bond returns. We run regressions of annual excess returns on forward rates. We find that a single factor predicts 1-year excess returns on 1-5 year maturity bonds with an R2 up to 43%. The single factor is a tent-shaped linear function of forward rates. The return forecasting factor has a clear business cycle correlation: Expected returns are high in bad times, and low in good times, and the return-forecasting factor forecasts long-run output growth. The return-forecasting factor also forecasts stock returns, suggesting a common time-varying premium for real interest rate risk. The return forecasting factor is poorly related to level, slope, and curvature movements in bond yields. Therefore, it represents a source of yield curve movement not captured by most term structure models. Though the return-forecasting factor accounts for more than 99% of the time-variation in expected excess bond returns, we find additional, very small factors that forecast equally small differences between long term bond returns, and hence statistically reject a one-factor model for expected returns.
*Published: Cochrane, John H. and Monika Piazzesi. "Bond Risk Premia," American Economic Review, 2005, v95(1,Mar), 138-160.
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