The present work deals with the headline topic of bond return predictability and to some extent with foreign exchange predictability. After a short overview of past research on bond return predictability the present work predominantely deals with the Cochrane-Piazzesi factor (CP-factor) which seemlingly predicts lagged bond excess returns better than all known models so far. The model is tested on a bunch of different data sets from different countries and underscores the superiority of this model in comparison to other bond predictability models, which are also explained. In the last section of the present work the CP-factor is used in order to test whether it is possible to explain the forward premium puzzle and thus is able to predict changes and excess returns in foreign exchange rates.
Table of Contents
1 Introduction
2 Bond return predictability in financial literature
2.1 Introduction
2.2 The expectation hypothesis
2.3 The Fama and Bliss model
2.4 The Campbell and Shiller model
3 The Cochrane and Piazzesi model
3.1 Short overview
3.2 Data and statistical issues
3.3 Methodology
3.4 Results
3.5 What kind of risk is captured by the CP-factor?
3.6 Critical appraisal
3.7 Conclusion
4 Testing the CP-factor on different data sets
4.1 The extended UFB data set
4.2 The Gurkaynak data set
4.3 CP-factor on Canada
4.4 CP-factor on Germany
4.5 CP-factor on other countries (Datastream data set)
4.6 Summary of bond return predictability
5 The CP-factor and FX predictability
5.1 Theoretical background concerning FX rates and FX forward contracts
5.2 UIP: Empirical findings
5.3 UIP and the CP-factor differential
5.4 Excess returns in FX rates and the CP-differential
6 Conclusion
Research Objective and Scope
The primary objective of this thesis is to empirically test the bond return predictability factor developed by Cochrane and Piazzesi (2005) across diverse international data sets to evaluate its robustness compared to traditional models like Fama and Bliss (1987) and principal component analysis. Furthermore, the work explores whether this CP-factor can predict exchange rate movements and contribute to resolving the forward premium puzzle in foreign exchange markets.
- Empirical evaluation of the CP-factor's predictive power within and outside the U.S.
- Comparison of the CP-factor against the Fama and Bliss (1987) and principal component models.
- Assessment of the tent-shaped pattern of regression coefficients across different data sets.
- Investigation into the CP-factor's ability to predict foreign exchange excess returns and interest rate parity.
Excerpt from the Book
3.1 Short overview
In contrast to Fama and Bliss (1987), who predicted bond excess returns on specific maturities with a R2 up to 18%, CP constructed a single factor (also referred to as the CP-factor) that predicts bond excess returns of all maturities with R2 values up to 44%. As the expectation hypothesis states inter alia that long-term yields should be equal to the average of the expected future short rates and thus excess return predictability is not feasible, the results of CP have strengthened the evidence against the expectation hypothesis. Their model regresses the lagged excess return against a linear combination of forward rates.
Summary of Chapters
1 Introduction: Provides an overview of bond return predictability research, introduces the CP-factor, and outlines the thesis goals regarding model testing and foreign exchange predictability.
2 Bond return predictability in financial literature: Details the theoretical foundations, including the expectation hypothesis and the models developed by Fama and Bliss, and Campbell and Shiller.
3 The Cochrane and Piazzesi model: Analyzes the methodology and findings of the CP-factor, addresses data construction concerns raised by Dai, Singleton and Yang, and examines the economic risk captured by the factor.
4 Testing the CP-factor on different data sets: Performs empirical tests of the CP-factor against alternative models on U.S., Canadian, German, and various international data sets to assess its global robustness.
5 The CP-factor and FX predictability: Investigates the application of the CP-factor differential to foreign exchange rates, specifically addressing uncovered interest parity and the forward premium puzzle.
6 Conclusion: Summarizes the thesis findings, confirming the superiority of the CP-factor in bond return predictability while noting the limitations of its application in foreign exchange markets.
Keywords
Bond Return Predictability, Cochrane and Piazzesi, CP-factor, Fama and Bliss, Expected Return Factor, Expectation Hypothesis, Risk Premium, Yield Curve, Principal Component Analysis, Foreign Exchange Predictability, Uncovered Interest Parity, Forward Premium Puzzle, Financial Econometrics, Time-Varying Risk, Monetary Policy.
Frequently Asked Questions
What is the core subject of this thesis?
The thesis examines the predictability of bond excess returns, specifically focusing on the performance of the Cochrane and Piazzesi (2005) single-factor model compared to traditional benchmarks.
What are the primary fields of study included?
The work spans financial econometrics, interest rate theory, term structure modeling, and international finance, particularly foreign exchange market dynamics.
What is the main research objective?
The goal is to determine if the CP-factor remains a superior predictor of bond returns across various international data sets and if it can effectively predict currency excess returns.
Which methodologies are employed in this analysis?
The author uses OLS regressions, principal component analysis (PCA), and Newey-West standard error corrections to perform in-sample tests of bond return predictability and uncovered interest parity.
What is covered in the main body of the work?
The analysis covers the theoretical evolution of return predictability, a detailed assessment of the Cochrane and Piazzesi model, extensive empirical testing across 15 different data sets, and a critical look at interpolation methods.
Which keywords best characterize this research?
The work is defined by terms such as Bond Return Predictability, CP-factor, Risk Premium, Uncovered Interest Parity, and Forward Premium Puzzle.
Why is the "tent-shaped pattern" a point of contention?
The tent-shaped pattern is a key visual finding of the CP model, but researchers like Dai, Singleton, and Yang argued it depends on the specific interpolation of the data; this thesis investigates whether this pattern persists in different datasets.
Does the CP-factor successfully solve the forward premium puzzle?
The research concludes that the CP-factor differential does not provide a robust solution to the forward premium puzzle, as results on predicting foreign exchange excess returns were largely statistically insignificant.
- Arbeit zitieren
- Thomas Mehlhaff (Autor:in), 2015, Bond Return Predictability. The Cochrane and Piazzesi model (CP-factor), München, GRIN Verlag, https://www.grin.com/document/314871
