A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets
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.
We would like to thank the participants of the SED 2012 meeting, Financial Research Association meeting, UBC Winter Conference, Duke University, University of Zurich and Wharton School, Geert Bekaert, Tim Bollerslev, Mikhail Chernov, Riccardo Colacito, Max Croce, Gregory Duffee, Bjorn Eraker, David Hsieh, Monika Piazzesi, Nikolai Roussanov, Ken Singleton, George Tauchen, Andrea Vedolin, Adrien Verdelhan, Pietro Veronesi, and Amir Yaron. Ravi Bansal (email: email@example.com, tel: 919-660-7758) is affiliated with the Fuqua School of Business, Duke University, and NBER. Send correspondence to Ivan Shaliastovich (email: firstname.lastname@example.org, tel: 215-746-0005), Wharton School, University of Pennsylvania. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Ravi Bansal & Ivan Shaliastovich, 2013. "A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets," Review of Financial Studies, vol 26(1), pages 1-33.