Consumption Risk and the Cross-Section of Government Bond Returns

Abhay Abhyankar, Olga Klinkowska, Soyeon Lee

Research output: Contribution to journalArticle

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Abstract

In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.
Original languageEnglish
Pages (from-to)180-200
Number of pages21
JournalJournal of Empirical Finance
Volume32
Early online date23 Mar 2015
DOIs
Publication statusPublished - Jun 2015

Fingerprint

Government bonds
Bond returns
Cross section
Bond portfolio
Consumption growth
Uncertainty
Factors
Innovation
VAR model
Common factors
Capital asset pricing model
Risk premium
Measure of risk
Maturity
Treasury bonds
Excess returns
Recursive preferences
Premium
Pricing
Financial data

Keywords

  • Epstein–Zin–Weil preferences
  • consumption risk
  • asset pricing tests
  • government bonds
  • factor analysis

Cite this

Consumption Risk and the Cross-Section of Government Bond Returns. / Abhyankar, Abhay; Klinkowska, Olga; Lee, Soyeon.

In: Journal of Empirical Finance, Vol. 32, 06.2015, p. 180-200.

Research output: Contribution to journalArticle

Abhyankar, Abhay ; Klinkowska, Olga ; Lee, Soyeon. / Consumption Risk and the Cross-Section of Government Bond Returns. In: Journal of Empirical Finance. 2015 ; Vol. 32. pp. 180-200.
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N2 - In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.

AB - In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.

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