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Decomposing Long Bond Returns: A Decentralized Theory

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  • Peter Carr
  • Liuren Wu

Abstract

Classic bond pricing centralizes bond valuation across all maturities by specifying the dynamics of the short-term interest rate. This article develops a decentralized theory that prices each bond based purely on the near-term behavior of the bond’s own yield. The theory levers the domain expertise of an investor on a particular bond and allows the investor to make pricing and investment analysis on the bond without the shackles of an ambitious centralizing mandate. The theory decomposes the short-term return on a bond with respect to the variation of its own yield. Imposing no dynamic arbitrage on the return decomposition leads to a simple pricing equation relating the bond yield to the market pricing and conditional mean and variance forecasts of the yield’s near-term change. The article illustrates the theory’s applications in decentralized investment of a single bond and in the construction and investment of decentralized butterfly bond portfolios.

Suggested Citation

  • Peter Carr & Liuren Wu, 2023. "Decomposing Long Bond Returns: A Decentralized Theory," Review of Finance, European Finance Association, vol. 27(3), pages 997-1026.
    • Handle: RePEc:oup:revfin:v:27:y:2023:i:3:p:997-1026.
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    File URL: http://hdl.handle.net/10.1093/rof/rfac053
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    More about this item

    Keywords

    Bond return decomposition; Yield decomposition; Duration; Convexity; Carry effect; Expectation; Risk premium; Local commonality; Butterfly trades;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • 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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