EDHEC is launching the EDHEC Bond Risk Premium Monitor in September 2017. Its purpose is to offer to the investment and academic communities a tool to quantify and analyse the risk premium associated with Government bonds (with an initial focus on US Treasuries).
We calculate the risk premium using two distinct methods: (i) a purely statistical method and (ii) a model-based method.
EDHEC is launching the EDHEC Bond Risk Premium Monitor in September 2017. Its purpose is to offer to the investment and academic community a tool to quantify and analyse the risk premium associated with Government bonds (with an initial focus on US Treasuries).
The following FAQs provide detailed explanations of what it can offer.
For a precise definition, see Cochrane (2001), Asset Pricing, Princeton University Press, or Rebonato (2018), Bond Pricing and Yield Curve Modelling – A Structural Approach, Cambridge University Press, Chapter 15.
In the case of (riskless) bonds, the risk premium is associated with the strategy of being ‘long duration’, (i.e. of funding a long position in a long-maturity bond by shorting a short-maturity bond). The strategy is often referred to as a ‘carry’ trade.
Risk premia provide timing (rather than cross-sectional) investment information. They answer the question, “Is today a good (bad) time to be long duration?” They do not answer the question, “Given that I have to be invested today, which bond gives the most attractive expected return?”
Risk premia also allow the market expectations about the future path of the short rate (Fed funds) to be extracted from the market yields.
We stress that changes in risk premia are more reliably estimated than the level of risk premia (the ‘slopes’ of the regressions have tighter confidence bands than the ‘intercepts’).
We also present the average of the four predictions, which is arguably the most reliable estimator.
(I) Strictly speaking, one should also take convexity into account. For a discussion, please refer to Rebonato (2018). Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press, Chapters 20-21.
(II) See Rebonato (2018). Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press, Chapter 24.
(III) See Cochrane, J. H. and M. Piazzesi (2005). Bond Risk Premia. American Economic Review 95(1): 138-160; for technical details, and the regression coefficients, see https://www.aeaweb.org/aer/data/mar05_app_cochrane.pdf (accessed on 25 November 2014).
(IV) Cieslak, A. and P. Povala (2010a). Understanding Bond Risk Premia. Working paper – Kellogg School of Management and University of Lugano, available at
https://www.gsb.stanford.edu/sites/default/files/documents/fin_01_11_Cie..., accessed on 5 May 2015, and Cieslak, A. and P. Povala (2010b). Expected Returns in Treasury Bonds, working paper, Northwestern University and Birbeck College, forthcoming in Review of Financial Studies.
(VI) Hatano, T. (2016). Investigation of Cyclical and Unconditional Excess Return Predicting Factors. MSc thesis – Oxford University.
(VII) See Rebonato (2018). Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press, Chapter 25 for a discussion of this point.
(VIII) For a chapter-length description of affine models, see, Piazzesi M. (2010), Affine Term Structure Models, Chapter 12 in Handbook of Financial Econometrics, Elsevier, or Bolder, D. J. (2001). Affine Term-Structure Models: Theory and Implementation, Bank of Canada, Working paper 2001-15, available at http://www.bankofcanada.ca/wp-content/uploads/2010/02/wp01-15a.pdf , accessed on 11 August 2017. For a book-length treatment, see Rebonato (2018), Bond Pricing and Yield-Curve Modelling – A Structural Approach, Cambridge University Press.
(IX) For a detailed description of the model, see Rebonato (2017). Reduced-Form Affine Models with Stochastic Market Price of Risk, International Journal of Theoretical and Applied Finance(forthcoming).
In this paper we discuss the common shortcomings of a large class of essentially-affine models in the current monetary environment of repressed rates, and we present a class of reduced-form stochastic-market-risk affine models that can overcome these problems. In
particular, we look at the extension of a popular doubly-mean-reverting Vasicek model, but the idea can be applied to all essentially-affine models.
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