Return Predictability and the Implied Intertemporal Hedging Demands for Stocks and Bonds: International Evidence

Abstract

We investigate return predictability and the implied intertemporal hedging demands for stocks and bonds in the U.S., Australia, Canada, France, Germany, Italy, and U.K. We first estimate predictive regression models for domestic bill, stock, and bond returns in each country, where returns depend on the nominal bill yield, dividend yield, and term spread. Employing the recently developed methodology of Campbell, Chan, and Viceira (2003), we calculate the implied optimal asset demands, including their myopic and intertemporal hedging components, for domestic bills, stocks, and bonds for an investor with an infinite horizon and Epstein-Zin-Weil utility in each country. We find that return predictability generates sizable positive intertemporal hedging demands for domestic stocks in the U.S. and U.K., while the intertemporal hedging demands for domestic stocks are decidedly smaller in Australia, Canada, and Germany and essentially zero in France and Italy. The intertemporal hedging demands for domestic bonds are negative and reasonably large in magnitude in the U.S., France, Germany, and Italy, while they are considerably smaller in magnitude in Australia, Canada, and the U.K. We also calculate optimal asset demands for an investor in the U.S. who, in addition to domestic bills, stocks, and bonds, has access to foreign stocks and bonds. We continue to find a sizable positive intertemporal hedging demand for U.S. stocks, and an important positive intertemporal hedging demand for U.K. stocks emerges. In another exercise, we find that investors in Australia, Canada, France, Germany, Italy, and the U.K. who have access to U.S. stocks and bonds all display sizable positive intertemporal hedging demands for U.S. stocks. Overall, we discover interesting similarities and differences in the implied intertemporal hedging demands for stocks and bonds across countries, and our results indicate that return predictability implies especially strong intertemporal hedging demands for U.S. and U.K. stocks