Inflation Risk and Inflation-Protected and Nominal Bonds
I decompose inflation risk into (i) a component that is correlated with real returns on positive-net-supply securities (stocks, real estate, etc.) and factors that determine investor’s preferences and investment opportunities and (ii) a residual component. In equilibrium, only the first component earns a risk premium. Therefore investors should avoid exposure to the residual component. All nominal bonds, including the nominal money-market account, are equally exposed to the residual component except inflation-protected bonds, which provide a means to hedge it. Every investor should put 100% of his wealth in positive-net-supply securities and inflation-protected bonds and should finance every long/short position in nominal bonds with an equal amount of other nominal bonds or by borrowing/lending in the nominal money market account; i.e. investors should hold a zero-investment portfolio of nominal bonds and the nominal money market account.
Disagreement about Inflation and the Yield Curve
(with Paul Ehling, Michael Gallmeyer, and Christian Heyerdahl-Larsen)
We study how differences in beliefs about expected inflation impact real and nominal yield curves in a frictionless economy. Inflation disagreement induces a spillover effect to the real side of the economy with a strong impact on the real yield curve. When investors have a coefficient of relative risk aversion greater than one, real yields across all maturities rise as disagreement increases. Real yield volatilities also rise with disagreement. Using the feature that nominal bond prices can be computed from weighted-averages of quadratic Gaussian yield curves, we explore three properties of the model numerically. First, both real and nominal yield curves are strongly impacted by inflation disagreement relative to a full information economy. Second, increased inflation disagreement drives nominal yields and nominal yield volatilities higher at all maturities. Third, expected inflation beliefs impact real yields. Empirical support for our predictions on yield levels and yield volatilities is provided.
(with Scott Condie and Jayant Ganguli)
We study how information about an asset affects optimal portfolios and equilibrium asset prices when investors are not sure about the model that predicts future asset values and thus treat the information as ambiguous. We show that this ambiguity leads to optimal portfolios that are insensitive to news even though there are no information processing costs or other market frictions. This insensitivity to news occurs even for risky portfolios in contrast to other ambiguity models where it only occurs for the risk-free portfolio. In equilibrium, we show that stock prices may not react to public information that is worse than expected and this mispricing of bad news leads to profitable trading strategies based on public information.
Risk Premia, Volatilities, and Sharpe Ratios in a Non-Linear Term Structure Model
(with Peter Feldhuetter and Christian Heyerdahl-Larsen)
In this paper we propose an expansion of Gaussian term structure models where the short rate and market prices of risk are non-linear in the state variables. We provide closed-form solutions for bond prices and since the latent factors are Gaussian the expanded model is as tractable as the Gaussian model. We estimate a three-factor expanded model and find that the model matches the time variation in both expected excess returns and yield volatilities of U.S. Treasury bonds. Comparing Sharpe ratios in the Gaussian and expanded model, the expanded model implies that Treasury bonds are more attractive investments in periods with low volatility. A significant part of expected excess returns in the expanded model is not spanned by the cross section of yields. This suggests that more information than previously thought is contained in the yield curve, but in a non-linear way.
FNCE 206/717 Financial Derivatives