The Volatility of Long-term Bond Returns: Persistent Interest Shocks and Time-varying Risk Premiums

Daniela Osterrieder () and Peter C. Schotman ()
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Daniela Osterrieder: Aarhus University and CREATES, Postal: Department of Economics and Business, Bartholins Allé 10, 8000 Aarhus C, DENMARK
Peter C. Schotman: Maastricht University, Postal: P.O. Box 616, 6200 MD Maastricht, The Netherlands

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We develop a model that can match two stylized facts of the term-structure. The first stylized fact is the predictability of excess returns on long-term bonds. Modeling this requires sufficient volatility and persistence in the price of risk. The second stylized fact is that long-term yields are dominated by a level factor, which requires persistence in the spot interest rate. We find that a fractionally integrated process for the short rate plus a fractionally integrated specification for the price of risk leads to an analytically tractable almost affine term structure model that can explain the stylized facts. In a decomposition of long-term bond returns we find that the expectations component from the level factor is more volatile than the returns themselves. It therefore takes a volatile risk premium that is negatively correlated with innovations in the level factor to explain the volatility of long-term bond returns. The model also implies that excess bond returns do not exhibit mean reversion, consistent with the empirical evidence.

Keywords: term structure of interest rates; fractional integration; affine models. (search for similar items in EconPapers)
JEL-codes: C32 C58 G12 (search for similar items in EconPapers)
Pages: 51
Date: 2012-08-03
New Economics Papers: this item is included in nep-fmk
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Citations: View citations in EconPapers (3)

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