Long forward probabilities, recovery, and the term structure of bond risk premiums

Likuan Qin; Vadim Linetsky; Yutian Nie

doi:10.1093/rfs/hhy042

Long forward probabilities, recovery, and the term structure of bond risk premiums

Likuan Qin, Vadim Linetsky^*, Yutian Nie

^*Corresponding author for this work

Industrial Engineering and Management Sciences

Research output: Contribution to journal › Article › peer-review

9 Scopus citations

Abstract

This paper examines the assumption of transition independence of the stochastic discount factor (SDF) in the bond market. This assumption underlies the recovery result of Ross 2015. Following the methodology of Alvarez and Jermann 2005 and Hansen and Scheinkman 2009, we estimate the martingale component in the long-term factorization of the SDF using U.S. Treasury data. The empirically estimated martingale component is highly volatile and produces a downward-sloping term structure of bond Sharpe ratios. In contrast, the transition independence assumption implies a degenerate martingale component and an upward-sloping term structure of bond Sharpe ratios. Thus, transition independence is inconsistent with our empirical results.

Original language	English (US)
Pages (from-to)	4863-4883
Number of pages	21
Journal	Review of Financial Studies
Volume	31
Issue number	12
DOIs	https://doi.org/10.1093/rfs/hhy042
State	Published - Dec 1 2018

Funding

This paper is based on research supported by grants from the National Science Foundation [CMMI-1536503 and DMS-1514698].SendcorrespondencetoVadimLinetsky,DepartmentofIndustrialEngineeringandManagement Sciences, Northwestern University, 1245 Sheridan Rd., Evanston, IL 60208; telephone: (847) 491 2084. E-mail: [email protected].

ASJC Scopus subject areas

Accounting
Finance
Economics and Econometrics

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N2 - This paper examines the assumption of transition independence of the stochastic discount factor (SDF) in the bond market. This assumption underlies the recovery result of Ross 2015. Following the methodology of Alvarez and Jermann 2005 and Hansen and Scheinkman 2009, we estimate the martingale component in the long-term factorization of the SDF using U.S. Treasury data. The empirically estimated martingale component is highly volatile and produces a downward-sloping term structure of bond Sharpe ratios. In contrast, the transition independence assumption implies a degenerate martingale component and an upward-sloping term structure of bond Sharpe ratios. Thus, transition independence is inconsistent with our empirical results.

AB - This paper examines the assumption of transition independence of the stochastic discount factor (SDF) in the bond market. This assumption underlies the recovery result of Ross 2015. Following the methodology of Alvarez and Jermann 2005 and Hansen and Scheinkman 2009, we estimate the martingale component in the long-term factorization of the SDF using U.S. Treasury data. The empirically estimated martingale component is highly volatile and produces a downward-sloping term structure of bond Sharpe ratios. In contrast, the transition independence assumption implies a degenerate martingale component and an upward-sloping term structure of bond Sharpe ratios. Thus, transition independence is inconsistent with our empirical results.

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Long forward probabilities, recovery, and the term structure of bond risk premiums

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