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APE-2: Term Structure II
Term Structure of Recession Probabilities and the Cross Section of Asset Returns
Southern University of Science and Technology
The duration of business cycles, especially recessions, is time-varying, generating time-varying investor concern about future recessions. I study a macro-factor asset pricing model that directly links risk premiums to time-varying investor concern about future recessions, measured by the term structure of recession probabilities from the Survey of Professional Forecasters. A linear factor model, including market excess return and the innovations to the level and slope of the term structure of recession probabilities, describes average returns on the Fama-French 25 size and book-to-market portfolios. The innovation to the slope is robustly priced in a wide range of testing assets with a negative market price of risk, consistent with the way how the slope of the term structure predicts future long-run macroeconomic activity. Finally, the tracking portfolios of the model help reconcile the joint cross section of returns on equities, currencies and equity index options and have comparable pricing performance to several return-based multi-factor benchmarks. These findings suggest that the slope of the term structure of recession probabilities is a recession state variable and an economic source of risk premia on these testing assets considered can be attributed to time-varying investor concern over future recessions that is priced.
Dynamics of the Expectation and Risk Premium in the OIS Term Structure
1Columbia University; 2Indiana University
We model the dynamics of the expectation and risk premium in the short-term OIS curve. The market expectation drove the OIS curve during 2002-2015 and caused the curve to invert before the Great Recession. The risk premium rose gradually before the global financial crisis and peaked in the early stage of the crisis. The Fed’s monetary policy lagged behind the market expectation before the crisis and moved ahead of the expectation during the crisis. We introduce dynamic term structure models to incorporate the public information on FOMC meeting schedules, which proves crucial for understanding the OIS curve.
Expected Term Structures
1Imperial College Business School; 2University of Oxford; 3Copenhagen Business School
This paper studies the properties of bond risk premia in the cross-section of subjective expectations. We exploit an extensive dataset of yield curve forecasts from financial institutions and document a number of novel findings. First, contrary to evidence presented for stock markets but consistent with rational expectations, the relation between subjective expectations and future realizations is positive, and this result holds for the entire cross-section of beliefs. Second, when predicting short term interest rates, primary dealers display superior forecasting ability when compared to non-primary dealers. Third, we reject the null hypothesis that subjective expected bond returns are constant. When predicting long term rates, however, primary dealers have no information advantage. This suggests that a key source of variation in long-term bonds are risk premia and not short- term rate variation. Fourth, we show that consensus beliefs are not a sufficient statistics to describe the cross-section of beliefs. Moreover, the beliefs of the most accurate agents are those most spanned by a contemporaneous cross-section of bond prices. This supports equilibrium models and Friedman’s market selection hypothesis. Finally, we use ex-ante spanned subjective beliefs to evaluate several reduced-form and structural models. We find support for heterogeneous beliefs models and also uncover a number of statistically significant relationships in favour of alternative rational expectations models once the effect of heterogeneous beliefs is taken into account.
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Conference: EFA 2017
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