Person:

Viceira, Luis

Expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist for long periods. Changes in investment opportunities can alter the risk–return trade-off of bonds, stocks, and cash across investment horizons, thus creating a “term structure” of the risk–return trade-off. This term structure can be extracted from a parsimonious model of return dynamics, as is illustrated with data from the U.S. stock and bond markets.

The exposure of US Treasury bonds to the stock market has moved considerably over time. While it was slightly positive on average in the period 1960-2011, it was unusually high in the 1980s and negative in the 2000s, a period during which Treasury bonds enabled investors to hedge macroeconomic risks. This paper explores the effects of monetary policy parameters and macroeconomic shocks on nominal bond risks, using a New Keynesian model with habit formation and discrete regime shifts in 1979 and 1997. The increase in bond risks after 1979 is attributed primarily to a shift in monetary policy towards a more anti-inflationary stance, while the more recent decrease in bond risks after 1997 is attributed primarily to an increase in the persistence of monetary policy interacting with continued shocks to the central bank’s inflation target. Endogenous responses of bond risk premia amplify these effects of monetary policy on bond risks.

This paper explores the history of inflation-indexed bond markets in the US and the UK. It documents a massive decline in long-term real interest rates from the 1990's until 2008, followed by a sudden spike in these rates during the financial crisis of 2008. Breakeven inflation rates, calculated from inflation- indexed and nominal government bond yields, stabilized until the fall of 2008, when they showed dramatic declines. The paper asks to what extent short-term real interest rates, bond risks, and liquidity explain the trends before 2008 and the unusual developments in the fall of 2008. Low inflation-indexed yields and high short-term volatility of inflation-indexed bond returns do not invalidate the basic case for these bonds, that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing going forward, even though they have offered high returns over the past decade.

This paper solves numerically the intertemporal consumption and portfolio choice problem of an infinitely-lived investor who faces a time-varying equity premium. The solutions we obtain are very similar to the approximate analytical solutions of Campbell and Viceira (1999), except at the upper extreme of the state space where both the numerical consumption and portfolio rules flatten out. We also consider a constrained version of the problem in which the investor faces borrowing and short-sales restrictions. These constraints bind when the equity premium moves away from its mean in either direction, and are particularly severe for risk-tolerant investors. The constraints have substantial effects on optimal consumption, but much more modest effects on optimal portfolio choice in the region of the state space where they are not binding.

Conventional wisdom holds that conservative investors should avoid exposure to foreign currency risk. Even if they hold foreign equities, they should hedge the currency exposure of these positions and hold only domestic Treasury bills. This paper argues that the conventional wisdom may be wrong for long-term investors. Domestic bills are risky for long-term investors, because real interest rates vary over time and bills must be rolled over at uncertain future interest rates. This risk can be hedged by holding foreign currency if the domestic currency tends to depreciate when the domestic real interest rate falls. Empirically this effect is important and can lead conservative long-term investors to hold more than half their wealth in foreign currency.

This paper presents an approximate analytical solution to the optimal consumption and portfolio choice problem of an infinitely lived investor with Epstein-Zin-Weil utility who faces a constant riskless interest rate and a time-varying equity premium. When the model is calibrated to U. S. stock market data, it implies that intertemporal hedging motives greatly increase, and may even double, the average demand for stocks by investors whose risk-aversion coefficients exceed one. The optimal portfolio policy also involves timing the stock market. Failure to time or to hedge can cause large welfare losses relative to the optimal policy.

Over the period 1975 to 2005, the US dollar (particularly in relation to the Canadian dollar) and the euro and Swiss franc (particularly in the second half of the period) have moved against world equity markets. Thus these currencies should be attractive to risk-minimizing global equity investors despite their low average returns. The risk-minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the US dollar. There is little evidence that risk-minimizing investors should adjust their currency positions in response to movements in interest differentials.

According to conventional wisdom, long-term bonds are appropriate for conservative long-term investors. This paper develops a model of optimal consumption and portfolio choice for infinite-lived investors with recursive utility who face stochastic interest rates, solves the model using an approximate analytical method, and evaluates conventional wisdom. As risk aversion increases, the myopic component of risky asset demand disappears but the intertemporal hedging component does not. Conservative investors hold assets to hedge the risk that real interest rates will decline. Long-term inflation-indexed bonds are most suitable for this purpose, but nominal bonds may also be used if inflation risk is low.

This paper derives an approximate solution to a continuous-time intertemporal portfolio and consumption choice problem. The problem is the continuous-time equivalent of the discrete-time problem studied by Campbell and Viceira (Q. J. Econ. 114 (1999) 433) in which the expected excess return on a risky asset follows an AR(1) process, while the riskless interest rate is constant. The paper also shows how to obtain continuous-time parameters that are consistent with discrete-time econometric estimates. The continuous-time solution is the limit of that of Campbell and Viceira and has the property that conservative long-term investors have a large positive intertemporal hedging demand for stocks.

We develop an approximate solution method for the optimal consumption and portfolio choice problem of an infinitely long-lived investor with Epstein–Zin utility who faces a set of asset returns described by a vector autoregression in returns and state variables. Empirical estimates in long-run annual and post-war quarterly U.S. data suggest that the predictability of stock returns greatly increases the optimal demand for stocks. The role of nominal bonds in long-term portfolios depends on the importance of real interest rate risk relative to other sources of risk. Long-term inflation-indexed bonds greatly increase the utility of conservative investors.