Bond Risk Premia and Realized Jump Risk
40 Pages Posted: 22 Dec 2008 Last revised: 14 Nov 2022
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Bond Risk Premia and Realized Jump Risk
Date Written: December 21, 2008
Abstract
We find that augmenting a regression of excess bond returns on the term structure of forward rates with a rolling estimate of the mean realized jump size-identified from high-frequency bond returns using the bi-power variation technique-increases the R2 of the regression from around 30 percent to 60 percent. This result is consistent with the setting of an unspanned risk factor in which the conditional distribution of excess bond returns is affected by a state variable that does not lie in the span of the term structure of yields or forward rates. The return predictability from augmenting the regression of excess bond returns on forward rates with the jump mean easily dominates the return predictability offered by instead augmenting the regression with options-implied volatility or realized volatility from high frequency data. In out-of-sample forecasting exercises, inclusion of the jump mean can reduce the root mean square prediction error by up to 40 percent. The unspanned risk factor-as proxied by realized jump mean in this paper-helps to account for the countercyclical movements in bond risk premia.
Keywords: Unspanned Stochastic Volatility, Expected Excess Bond Returns, Expectations Hypothesis, Countercyclical Risk Premia, Realized Jump Risk, Bi-Power Variation.
JEL Classification: G12, G14, E43, C22.
Suggested Citation: Suggested Citation