Job Market Paper


A Disaster Explanation for the Term Structure of Returns

This paper incorporates recovery of dividend in addition to the drop in dividend and the rise in inflation in disaster framework so that the cash flow effect of disaster is contemporary for realized variance, transitory for dividend, and accumulative for nominal bond. The new framework accounts for the following facts (1) term structure of holding period return and its Sharpe ratio of dividend strip are downward sloping, as found by van Binsbergen, Brandt, and Koijen (2012) (2) term structure of holding period return of nominal bond is upward sloping while its Sharpe ratio is downward sloping, as found by van Binsbergen and Koijen (2017), and (3) Sharpe ratio of holding period return is significantly negative for one month variance forward, and close to zero for variance forward with maturity longer than two months, as found by Dew-Becker, Giglio, Le, and Rodriguez (2017). The model also predicts pro cyclical slope of dividend yield curve and pro cyclical slope of variance forward price curve. An international extension explains the fact that (4) either sorted by short rate or negative term premia, carry trade using short term bond is profitable while carry trade with long term bond is not, as found by Lustig, Stathopoulos, and Verdelhan (2016). The model suggests the following new trading strategy should have high return: sort countries by a linear combination of three forward rates that measures the country‚Äôs exposure to the jump in inflation induced by disaster, and trades a synthetic slope that longs/shorts two bonds with different maturity which is directly exposed to the jump. The Sharpe ratio is 1.34, consistent with the notion that asset highly exposed to disaster risk earns high return.