Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors / Antonios Sangvinatsos, Jessica A. Wachter.

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Sangvinatsos, Antonios

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w10086.Publication details: Cambridge, Mass. National Bureau of Economic Research 2003.Description: 1 online resource: illustrations (black and white)Subject(s):

G1 - General Financial Markets

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Abstract: We consider the consumption and portfolio choice problem of a long-run investor when the term structure is affine and when the investor has access to nominal bonds and a stock portfolio. In the presence of unhedgeable inflation risk, there exist multiple pricing kernels that produce the same bond prices, but a unique pricing kernel equal to the marginal utility of the investor. We apply our method to a three-factor Gaussian model with a time-varying price of risk that captures the failure of the expectations hypothesis seen in the data. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio for the long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, the desire to hedge changes in term premia generates large hedging demands for long-term bonds.

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November 2003.

We consider the consumption and portfolio choice problem of a long-run investor when the term structure is affine and when the investor has access to nominal bonds and a stock portfolio. In the presence of unhedgeable inflation risk, there exist multiple pricing kernels that produce the same bond prices, but a unique pricing kernel equal to the marginal utility of the investor. We apply our method to a three-factor Gaussian model with a time-varying price of risk that captures the failure of the expectations hypothesis seen in the data. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio for the long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, the desire to hedge changes in term premia generates large hedging demands for long-term bonds.