Saturday, December 6, 2014

Risk and Return in the Bond Markets


Chan Mang
Finance economists seek to explain the term structure of bond prices. Why do long bonds typically earn a higher yield than short bonds and how do the yields for bonds of different maturities move over time? A graph of these yields as a function of duration  is called the yield curve.

Figure 1 is a graph of the yield curve, taken from the Treasury Website, for December 14th 2014. 

Figure 1:
The graph shows that one month treasuries are currently paying an interest rate of zero. However, longer denomination treasuries have higher yields that increase monotonically with duration and thirty year bonds are currently paying 3%.  This pattern is not time invariant and there have been periods when the yield curve is flat or even downward sloping over some regions.

Figure 2 compares the yield curve from December 2014, with that from February 2006. Back in 2006 the yield on six month treasuries was over 4.6%, but the yield on five year securities was lower at 4.5%. When long yields are lower than short yields, the yield curve is said to be inverted, and historically, an inverted yield curve has been the harbinger of a recession.
Figure 2
Back to the main story.  Finance theorists explain the yield curve with what they call 'factor models'. They look at the evolution of yield curves over time and they seek common components that help to explain how all of the yields move over time.  Cochrane and Piazzesi developed the state of the art factor model to understand these phenomena.

Enter Chan Mang. In Chan's words

In my work, I show that the affine term structure model of Cochrane and Piazzesi (2008) has inconsistent predictions when I compare different financial markets. ... [because] the additional information in the term structure ... generates an implausible amount of predictability in exchange rates and currency excess returns. 
[I find that] ... it is either the case that bond excess returns or currency returns are predictable, but not both at the same time.
To understand these features of the data, Chan is developing a theoretical model that connects the Cochrane-Piazzesi explanation with what monetary policy makers think they are doing.

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