Working Paper: NBER ID: w16903
Authors: Carolin E. Pflueger; Luis M. Viceira
Abstract: This paper empirically analyzes the Expectations Hypothesis (EH) in inflation-indexed (or real) bonds and in nominal bonds in the US and in the UK. We strongly reject the EH in inflation-indexed bonds, and also confirm and update the existing evidence rejecting the EH in nominal bonds. This rejection implies that the risk premium on both real and nominal bonds varies predictably over time. We also find strong evidence that the spread between the nominal and the real bond risk premium, or the break-even inflation risk premium, also varies over time. We argue that the time variation in real bond risk premia mostly likely reflects both a changing real interest rate risk premium and a changing liquidity risk premium, and that the variability in the nominal bond risk premia reflects a changing inflation risk premium. We estimate significant time series variability in the magnitude and sign of bond risk premia.
Keywords: No keywords provided
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expectations Hypothesis (EH) is strongly rejected for inflation-indexed bonds (E43) | Risk premium on inflation-indexed bonds is not constant over time (E31) |
| Variability in real bond risk premia reflects changing real interest rate risk premium and changing liquidity risk premium (E43) | Variability in real bond risk premia (E43) |
| Spread between nominal and real bond risk premia is time-varying (E43) | Inflation risk and premium demanded by investors are not constant (E31) |
| Rejection of nominal EH implies expected breakeven inflation returns are not constant (D84) | Time-varying inflation risk premium (E31) |
| Risk premium on nominal bonds varies predictably over time (E43) | Term spread can predict bond returns (G12) |