Trends in excess returns in currency and bond markets

Abstract

Recent empirical evidence finds that asset prices are characterized by processes subject to permanent shocks that cumulate into trends. By contrast, theoretical and empirical research usually treats excess returns as following processes subject to purely temporary shocks. The implicit assumption behind this treatment is that the permanent shocks to asset prices cancel out when they are combined to form excess returns. In this paper, we test this hypothesis for foreign exchange and bond returns. Surprisingly, we reject the hypothesis for a wide range of returns, suggesting that there are trends in excess returns. We offer two possible explanations for the presence of these trends. Monte Carlo experiments show that either explanation could produce trends in excess returns in finite samples consistent with our empirical findings.

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