Bond Risk Premia and Business Cycle (in Korean)

Joonhyuk Song () and Youngsoo Choi ()
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Joonhyuk Song: KDI (Korea Development Institute)
Youngsoo Choi: Hankuk University of Foreign Studies

Economic Analysis (Quarterly), 2008, vol. 14, issue 4, 1-46

Abstract: This paper aims to study the empirical evidence of existence of expectations hypothesis in Korean bond markets and to discuss the theoretical and empirical implications of return-forecasting factors, introduced by Cochrane and Piazzesi (2005). Empirical results show that the expectations hypothesis is not supported in Korean bond markets, which concludes that the bond risk premia are time-varying. Combining the return-forecasting factor with interest rate models, we found the factor is closely related with interest rate volatility, and empirical tests also support theoretical predictions. Considering interest volatility being highly correlated with business cycles, we conjecture that the return-forecasting factor can be employed as a valid predictor of business cycles or recessions. We test the effectiveness of the return-forecasting factor to predict coincident indicator, industrial production gap, and CPI inflation and find the predictive powers are comfortably high ranging between 20~50%. Besides, we also construct a Probit model to verify how effectively the return-forecasting factor predict the arrival of recessions. Estimation results show that the starts of recession are well predicted by the return-forecasting factor, while stock returns are poor in predicting the arrival. Considering its high predictive power, the return-forecasting factor is expected to be used as an auxiliary indicator to the current leading indicators.

Keywords: Expectations hypothesis; Risk premia; Return forecasting factor; Volatility (search for similar items in EconPapers)
JEL-codes: E37 G10 G12 (search for similar items in EconPapers)
Date: 2008
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