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The Term Structure of the Risk-Return Tradeoff

John Campbell () and Luis Viceira ()

No 11119, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. In this paper we propose an empirical model that is able to capture these complex dynamics, yet is simple to apply in practice, and we explore its implications for asset allocation. Changes in investment opportunities can alter the risk-return tradeoff of bonds, stocks, and cash across investment horizons, thus creating a ``term structure of the risk-return tradeoff.'' We show how to extract this term structure from our parsimonious model of return dynamics, and illustrate our approach using data from the U.S. stock and bond markets. We find that asset return predictability has important effects on the variance and correlation structure of returns on stocks, bonds and T-bills across investment horizons.

JEL-codes: G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin, nep-mon and nep-rmg
Date: 2005-02
Note: AP
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Published as Campbell, John Y. and Luis Viceira. "The Term Structure of the Risk-Return Tradeoff.” Financial Analysts Journal 61 (January/February 2005): 34-44.

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