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

Torben G. Andersen () and Luca Benzoni ()
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Luca Benzoni: School of Economics and Management, University of Aarhus, Denmark and CREATES, Postal: 8000 Aarhus C, Denmark

CREATES Research Papers from School of Economics and Management, University of Aarhus

Abstract: 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.

New Economics Papers: this item is included in nep-fmk and nep-mst
Date: 2007-09-17
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Related works:
Working Paper: Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification test for Affine Term Structure Models (2007)
Working Paper: Do bonds span volatility risk in the U.S. Treasury market? a specification test for affine term structure models (2006)
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Persistent link: http://EconPapers.repec.org/RePEc:aah:create:2007-25

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