[This paper studies the term structure implications of a simple structural model in which the representative agent displays ambiguity aversion, modeled by Multiple Priors Recursive Utility. Bond excess returns reflect a premium for ambiguity, which is observationally distinct from the risk premium of affine yield curve models. The ambiguity premium can be large even in the simplest log-utility setting and is also nonzero for stochastic factors that have a zero risk premium. A calibrated low-dimensional two-factor model with ambiguity is able to reproduce the deviations from the expectations hypothesis documented in the literature, without modifying in a substantial way the nonlinear mean-reversion dynamics of the short interest rate. Moreover, the model does not imply any apparent trade-off between fitting the first and second moments of the yield curve.]

This paper studies the term structure implications of a simple structural model in which the representative agent displays ambiguity aversion, modeled by Multiple Priors Recursive Utility. Bond excess returns reflect a premium for ambiguity, which is observationally distinct from the risk premium of affine yield curve models. The ambiguity premium can be large even in the simplest log-utility setting and is also nonzero for stochastic factors that have a zero risk premium. A calibrated low-dimensional two-factor model with ambiguity is able to reproduce the deviations from the expectations hypothesis documented in the literature, without modifying in a substantial way the nonlinear mean-reversion dynamics of the short interest rate. Moreover, the model does not imply any apparent trade-off between fitting the first and second moments of the yield curve. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

ABSTRACT We develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the degree of correlation across industries, countries, or asset classes is stochastic. Optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. We find that the hedging demand is typically larger than in univariate models, and it includes an economically significant covariance hedging component, which tends to increase with the persistence of variance–covariance shocks, the strength of leverage effects, the dimension of the investment opportunity set, and the presence of portfolio constraints.