Does the Failure of the Expectations Hypothesis Matter for Long-Term Investors?



    1. 1Stern School of Business at New York University
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    1. 2Wharton School at the University of Pennsylvania, and the NBER
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    • Sangvinatsos is at the Stern School of Business at New York University. Wachter is at the Wharton School at the University of Pennsylvania and the NBER. The authors are grateful for helpful comments from Utpal Bhattacharya, Michael Brennan, John Campbell, Jennifer Carpenter, Qiang Dai, Ned Elton, Rick Green, Blake LeBaron, Anthony Lynch, Lasse Pedersen, Matthew Richardson, Luis Viceira, an anonymous referee, and seminar participants at Brandeis University, the Norwegian School of Economics and Business, the Norwegian School of Management, University of California at Los Angeles, Indiana University at Bloomington, the Spring 2003 NBER Asset Pricing meeting, and the 2003 CIREQ-CIRANO-MITACS Conference on Portfolio Choice.


We solve the portfolio problem of a long-run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock. We apply our method to a three-factor model that captures the failure of the expectations hypothesis. We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data. The estimates imply that the bond portfolio of a long-run investor looks very different from the portfolio of a mean-variance optimizer. In particular, time-varying term premia generate large hedging demands for long-term bonds.