Understanding the Predictability of Excess Returns∗

A seminal paper by Fama and Bliss (1987) showed that a simple regression model could explain a significant portion of 1-year ahead excess returns. Cochrane and Piazzesi (2005) showed that their regression model could explain a significantly large portion of excess returns than Fama and Bliss’ model and that a single return-forecasting factor essentially encompassed the predictability of excess returns for all of the bonds considered. This paper show; the source of the in-sample predictability of Fama and Bliss’ and Cochrane and Piazzesi’s regression models, the source of the encompassing power of Cochrane and Piazzesi’s return-forecasting factor, why the return-forecasting factor increases the predictability of bond yields relative to a standard 3-factor term structure model, and why longer-term forward rates predict excess returns on shortterm securities. JEL classification: G0; G1; E0; E4.