Working Paper: CEPR ID: DP13874
Authors: Antonio Mele; Yoshiki Obayashi; Shihao Yang
Abstract: How valuable would it be to mitigate government debt volatility? This paper introduces a model that accounts for the complex structure of expected volatility in government bond markets and provides predictions regarding the fair value of derivatives referenced to this expected volatility. The model predicts that, unlike equity markets, futures markets on government bond volatilities frequently oscillate between episodes of backwardation and contango. This property helps explain events such as the reaction of the U.S. Treasury volatility curve to shocks including unanticipated Fed decisions or global economic imbalances. The paper provides quasi-closed form solutions that can readily be implemented despite the high-dimensional no-arbitrage restrictions that underlie the model dynamics.
Keywords: Fixed Income; Volatility; Information Content of Government Bond Volatility; Government Bond Variance Swaps; Treasury Markets
JEL Codes: G12; G13; E43; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government bond volatility (G12) | derivative pricing (G13) |
| short-term and long-term factors (E71) | government bond volatility (G12) |
| increased uncertainty (D89) | term structure of government bond volatility (E43) |
| derivatives on government bond volatility (E43) | improved portfolio performance (G11) |
| government bond volatility (G12) | volatility indices (G17) |
| market shocks (G17) | behavior of volatility indices (C58) |