Essays on predictability of equity and bond risk premia

Abstract

The purpose of this thesis is to investigate the evidence of return predictability in equity and treasury markets. The first topic investigates the evidence on return predictability from an economic perspective. We use a simple model that incorporates a time varying investment opportunity set into a mean-variance portfolio maximization framework, and derive the optimal capital allocation weights for: (i) a naive strategy based on average realized returns; and (ii) a class of strategies that condition on dividend-price signals. While our data supports in-sample evidence of return predictability, the out-of-sample returns of the naive strategy are higher than those of all conditional portfolio specifications based on a certainty equivalent metric and portfolio turnover. These results suggest that dividendprice predictability offers no economic value to investors. The second topic studies the link between short and long-run risk premia of equity claims. We extract short-term risk premia from contemporaneous information on short-term futures and cash equity markets under the assumption of no arbitrage. Predictability regressions reveal that short-term risk premia capture different information from long-run risk premia. Counter to the intuition that a high price of risk commands high returns, high short-run risk premia on dividend claims predict low returns on the index. While inconsistent with models featuring either habit persistence or long-run risk, the results may be reconciled with some models of uncertainty aversion. The third topic is concerned with monetary policy sources of bond risk premia. Expected monetary policy shocks are extracted from a panel of inflation, GDP growth, and federal funds rates forecasts and using a Taylor rule specification as an identifying assumption. Expected monetary policy shocks are found to be statistically significant predictors of excess returns on bonds, even after controlling for levels and conditional volatilities of macroeconomic activity. The findings are consistent with a long run risk economy where contractionary monetary policy action increases GDP uncertainty.