Markus Sihvonen (Aalto University School of Business): Bonds, currencies and expectational errors

Markus Sihvonen (Aalto University School of Business): Bonds, currencies and expectational errors

Abstract

I propose a simple no-arbitrage model for explaining bond and currency returns that is consistent with the systematic expectational errors documented in surveys. The implied term premium is on average positive but time-varying due to expectational errors. The model matches the violations of uncovered interest rate parity and creates the observed downward sloping term structure of carry trade returns because underpriced currencies tend to have overpriced long-term bonds. It also explains other currency and bond anomalies such as delayed overshooting, the currency variance and persistence puzzles and the puzzle of excess volatility of long-term yields. It matches survey evidence in that forecasters (i) underweight the importance of recent interest rate shocks on future interest rates, (ii) underestimate the future strength of high interest rate currencies and (iii) overstate the impact of an upwardsloping yield curve on future interest rates.

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