Working Paper: NBER ID: w28444
Authors: Jennifer N. Carpenter; Fangzhou Lu; Robert F. Whitelaw
Abstract: Studies of the dynamics of bond risk premia that do not account for the corresponding dynamics of bond risk are hard to interpret. We propose a new approach to modeling bond risk and risk premia. For each of the US and China, we reduce the government bond market to its first two principal-component bond-factor portfolios. For each bond-factor portfolio, we estimate the joint dynamics of its volatility and Sharpe ratio as functions of yield curve variables, and of VIX in the US. We have three main findings. (1) There is an important second factor in bond risk premia. (2) Time variation in bond return volatility is as important as time variation in bond Sharpe ratios. (3) Bond risk premia are solely compensation for bond risk, as no-arbitrage theory predicts. Our approach also allows us to document interesting cyclical and secular time-variation in the term structure of bond risk premia in both the US and China.
Keywords: No keywords provided
JEL Codes: G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| second factor (Y50) | price of risk associated with longer maturities (G19) |
| bond return volatility (G12) | bond risk premia (G12) |
| bond volatility approaches zero (G12) | bond risk premia converge to zero (G12) |
| monetary policy (E52) | volatility declines in China (G17) |
| monetary policy (E52) | Sharpe ratios increase in China (G19) |
| volatility declines in China (G17) | Sharpe ratios increase (G40) |
| Sharpe ratios increase (G40) | negative correlation with volatility in China (G17) |
| Sharpe ratios increase (G40) | positive correlation with volatility in U.S. market (G17) |