Long Forward Probabilities, Recovery and the Term Structure of Bond Risk Premiums

We show that the martingale component in the long-term factorization of the stochastic discount factor due to Alvarez and Jermann (2005) and Hansen and Scheinkman (2009) is highly volatile, produces a downward-sloping term structure of bond Sharpe ratios, and implies that the long bond is far from growth optimality. In contrast, the long forward probabilities forecast an upward sloping term structure of bond Sharpe ratios that starts from zero for short-term bonds and implies that the long bond is growth optimal. Thus, transition independence and degeneracy of the martingale component are implausible assumptions in the bond market.

• Publication year

  2016

• Venue

  Review of Financial Studies

• Publication date

  2016-01-24

• Fields of study

  Mathematics, Economics

• Identifiers
  DOI 10.2139/SSRN.2721366arXiv 1601.06477
• External record

  Open on Semantic Scholar

• Source metadata

  Semantic Scholar

• No claims are published for this paper.

• No concepts are published for this paper.

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