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Unspanned stochastic volatility from an empirical and practical perspective

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  • Backwell, Alex

Abstract

I conduct a simulation study to address concerns raised in the empirical literature on unspanned stochastic volatility (USV, i.e., interest-rate-volatility risk that cannot be hedged with bonds or swaps). Regressions have been the popular method of identifying and measuring USV, and have led to a consensus that is in favour of USV models. Despite plausible challenges to this approach, my simulations show that regressions are able to correctly identify the presence and absence of USV. This relies on a number of methodological considerations which are inconsistent in the literature. Regression results from empirical data, from several modern interest-rate markets, resemble results from data simulated from USV models. I then assess the economic significance of USV. By comparing hedged and unhedged returns of market interest-rate options, I develop quantitative guidelines around how unspanned volatility risk compares to interest-rate risk.

Suggested Citation

  • Backwell, Alex, 2021. "Unspanned stochastic volatility from an empirical and practical perspective," Journal of Banking & Finance, Elsevier, vol. 122(C).
    • Handle: RePEc:eee:jbfina:v:122:y:2021:i:c:s0378426620302557
    DOI: 10.1016/j.jbankfin.2020.105993
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    References listed on IDEAS

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    More about this item

    Keywords

    Interest-rate volatility; Unspanned stochastic volatility; Volatility risk; Hedging; Market incompleteness; Term structure models;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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