Uncertain Risk and Return in Bond Markets, I

I use the term structure model in Cochrane and Piazzesi (2008) and construct currency market prices. The implied currency market prices are counterfactually volatile and predictable, at least with respect to commonly used predictor variables. Getting the model closer to currency market data means reducing bond risk compensation but doing so nearly eliminates predictability in bond markets. One way to generate sensible time-variation in predictable bond and currency excess returns allows the volatility of returns to be time-varying. Additional avenues that can jointly account for the stochastic properties of bond and currency excess returns are also discussed.