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Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models

Listed author(s):
  • Torben G. Andersen
  • Luca Benzoni

    ()

    (School of Economics and Management, University of Aarhus, Denmark and CREATES)

We investigate whether bonds span the volatility risk in the U.S. Treasury market, as predicted by most `a±ne' term structure models. To this end, we construct powerful and model-free empirical measures of the quadratic yield variation for a cross-section of ¯xed-maturity zero-coupon bonds (`realized yield volatility') through the use of high-frequency data. We ¯nd 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 a±ne di®usive, Gaussian-quadratic and a±ne jump-di®usive 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 speci¯cation testing and (parametric) model selection within the term structure literature.

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File URL: ftp://ftp.econ.au.dk/creates/rp/07/rp07_25.pdf
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Paper provided by Department of Economics and Business Economics, Aarhus University in its series CREATES Research Papers with number 2007-25.

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Length: 59
Date of creation: 17 Sep 2007
Handle: RePEc:aah:create:2007-25
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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  14. Andersen, Torben G. & Bollerslev, Tim, 1997. "Intraday periodicity and volatility persistence in financial markets," Journal of Empirical Finance, Elsevier, vol. 4(2-3), pages 115-158, June.
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  16. Das, Sanjiv R., 2002. "The surprise element: jumps in interest rates," Journal of Econometrics, Elsevier, vol. 106(1), pages 27-65, January.
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  24. Torben G. Andersen & Tim Bollerslev & Francis X. Diebold & Paul Labys, 2003. "Modeling and Forecasting Realized Volatility," Econometrica, Econometric Society, vol. 71(2), pages 579-625, March.
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  30. Ole E. Barndorff-Nielsen & Neil Shephard, 2002. "Estimating quadratic variation using realized variance," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 17(5), pages 457-477.
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