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Spanned stochastic volatility in bond markets: a reexamination of the relative pricing between bonds and bond options

  • Don H Kim
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    This paper reexamines the issue of unspanned stochastic volatility (USV) in bond markets and the puzzle of poor relative pricing between bonds and bond options. I make a distinction between the "weak USV" and the "strong USV" scenarios, and analyze the evidence for each of them. I argue that the poor bonds/options relative pricing in the extant literature is not necessarily evidence for the strong USV scenario, and show that a maximally flexible 2-factor quadratic-Gaussian model (a non-USV model) estimated without bond options data can capture much of the movement in bond option prices. Dropping the positive-definiteness requirement for nominal interest rates and adopting "regularized" estimations turn out to be important for obtaining sensible results.

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    Paper provided by Bank for International Settlements in its series BIS Working Papers with number 239.

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    Length: 40 pages
    Date of creation: Dec 2007
    Date of revision:
    Handle: RePEc:bis:biswps:239
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    6. Torben G. Andersen & Luca Benzoni, 2010. "Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 65(2), pages 603-653, 04.
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    9. Pierre Collin-Dufresne & Robert S. Goldstein, 2002. "Do Bonds Span the Fixed Income Markets? Theory and Evidence for Unspanned Stochastic Volatility," Journal of Finance, American Finance Association, vol. 57(4), pages 1685-1730, 08.
    10. Pierre Collin-Dufresne & Christopher S. Jones & Robert S. Goldstein, 2004. "Can Interest Rate Volatility be Extracted from the Cross Section of Bond Yields? An Investigation of Unspanned Stochastic Volatility," NBER Working Papers 10756, National Bureau of Economic Research, Inc.
    11. David K. Backus & Jonathan H. Wright, 2007. "Cracking the Conundrum," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 38(1), pages 293-329.
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    14. Kim, Don H. & Orphanides, Athanasios, 2005. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," CEPR Discussion Papers 5341, C.E.P.R. Discussion Papers.
    15. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
    16. Nicholas Economides, 2007. "Nonbanks in the Payments System: Vertical Integration Issues," Working Papers 07-06, NET Institute.
    17. Markus Leippold & Liuren Wu, 2002. "Design and Estimation of Quadratic Term Structure Models," Finance 0207014, EconWPA.
    18. Michael J. Fleming & Eli M. Remolona, 1997. "What moves the bond market?," Economic Policy Review, Federal Reserve Bank of New York, issue Dec, pages 31-50.
    19. Black, Fischer, 1995. " Interest Rates as Options," Journal of Finance, American Finance Association, vol. 50(5), pages 1371-76, December.
    20. Don H Kim & Athanasios Orphanides, 2007. "The bond market term premium: what is it, and how can we measure it?," BIS Quarterly Review, Bank for International Settlements, June.
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