Working Paper: NBER ID: w12962
Authors: Torben G. Andersen; Luca Benzoni
Abstract: We investigate whether bonds span the volatility risk in the U.S. Treasury market, as predicted by most 'affine' term structure models. To this end, we construct powerful and model-free empirical measures of the quadratic yield variation for a cross-section of fixed-maturity zero-coupon bonds ("realized yield volatility") through the use of high-frequency data. We find that the yield curve fails to span yield volatility, as the systematic volatility factors are largely unrelated to the cross-section of yields. We conclude that a broad class of affine diffusive, Gaussian-quadratic and affine jump-diffusive models is incapable of accommodating the observed yield volatility dynamics. An important implication is that the bond markets per se are incomplete and yield volatility risk cannot be hedged by taking positions solely in the Treasury bond market. We also advocate using the empirical realized yield volatility measures more broadly as a basis for specification testing and (parametric) model selection within the term structure literature.
Keywords: bonds; volatility risk; affine term structure models; US Treasury market
JEL Codes: C14; C32; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| yield curve fails to span yield volatility (G19) | lack of correlation between systematic volatility factors and the cross-section of yields (C10) |
| realized yield volatility (G17) | principal components of bond yields (E43) |
| first three principal components (level, slope, curvature) (C29) | insignificant coefficients (C20) |
| higher-order components (Y80) | limited explanatory power (C29) |
| predictable yield variation (C29) | largely unrelated to the yield curve (G19) |
| affine jump-diffusion models (C58) | conditional volatility spanning conditions (C58) |