Pricing and Constructing International Government Bond Portfolios

Abstract:

In developed government bond markets, even simple diversification strategies are shown to offer significant benefits due to imperfectly correlated term-structure dynamics. We derive a stochastic discount factor to price this asset class by projecting returns onto the unconditional mean-variance efficient portfolio. The resulting market price of risk varies substantially over time, peaking during crises and periods of inflation rate dispersion. International bond returns exhibit a strong factor structure, but common sources of return variation show little connection to priced risks. Hedging unpriced risks from naive or factor-based strategies enhances Sharpe ratios significantly, even when portfolio weight limits are imposed.