Unspanned Stochastic Volatility: Empirical Evidence and Affine Representation
AbstractMost models of the term structure are restrictive in that they assume the bond market forms a complete market. That is, they assume all sources of risk affecting fixed income derivatives can be completely hedged by a portfolio consisting solely of bonds. Below, we demonstrate that this prediction fails in practice. In particular, we find that changes in swap rates have very limited explanatory power for returns on at-the-money straddles -- portfolios mainly exposed to volatility risk. We term this empirical feature `unspanned' stochastic volatility (USV). We demonstrate that bivariate Markov (affine such as Fong and Vasicek (1991) and Longstaff and Schwartz (1992), or not) models cannot exhibit USV. Then, we determine necessary (and apparently sufficient) parameter restrictions for trivariate Markov affine systems to exhibit USV. Finally, we show that USV occurs naturally within the Heath-Jarrow-Morton framework.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 2001-E9.
Date of creation:
Date of revision:
Contact details of provider:
Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
Web page: http://www.tepper.cmu.edu/
This paper has been announced in the following NEP Reports:
You can help add them by filling out this form.
reading list or among the top items on IDEAS.Access and download statisticsgeneral information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Steve Spear).
If references are entirely missing, you can add them using this form.