| Abstract: |
Recent research in empirical finance has documented that expected excess
returns on bonds and stocks, real interest rates, and risk shift over time in
predictable ways. Furthermore, these shifts tend to persist over long periods
of time. In this paper we propose an empirical model that is able to capture
these complex dynamics, yet is simple to apply in practice, and we explore its
implications for asset allocation. Changes in investment opportunities can
alter the risk-return tradeoff of bonds, stocks, and cash across investment
horizons, thus creating a ``term structure of the risk-return tradeoff.'' We
show how to extract this term structure from our parsimonious model of return
dynamics, and illustrate our approach using data from the U.S. stock and bond
markets. We find that asset return predictability has important effects on the
variance and correlation structure of returns on stocks, bonds and T-bills
across investment horizons. |