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A beta based framework for (lower) bond risk premia

Stefano Nobili and Gerardo Palazzo ()
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Gerardo Palazzo: Bank of Italy, Asset Management Department

No 689, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: We use a no-arbitrage essentially affine three-factor model to estimate term premia in US and German ten-year government bond yields. In line with the existing literature, we find that estimated premia have followed a downward trend since the 1980s: from 4.9 per cent in 1981 to 0.7 per cent in 2006 for the US bond and from 3.3 to 0.5 per cent for the German one. Subsequently, using an Error Correction Model (ECM) we prove that the decline is explained by a decrease in global output variability and an increase in the power of ten-year government bonds to diversify the investors’ portfolios. In addition, the ECM also forecasts both the US and the German term premia converging to around one percentage point over a five year horizon. Long-term return expectations for ten-year government bonds will have to incorporate bond risk premia that - while in line with average excess returns during the twentieth century - are significantly lower than average excess returns over the last two decades.

Keywords: Term structure model; bond risk premium; modern portfolio theory (search for similar items in EconPapers)
JEL-codes: C13 C14 E43 E47 G12 G15 (search for similar items in EconPapers)
Date: 2008-09
New Economics Papers: this item is included in nep-mac
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