Do bonds span volatility risk in the U.S. Treasury market? a specification test for affine term structure models

Torben Andersen and Luca Benzoni

No WP-06-15, Working Paper Series from Federal Reserve Bank of Chicago

Abstract: We investigate whether bonds span the volatility risk in the U.S. Treasury market, as predicted by most 'affine' term structure models. To this end, we construct powerful and model-free empirical measures of the quadratic yield variation for a cross-section of fixed- maturity zero-coupon bonds ('realized yield volatility') through the use of high-frequency data. We find 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 affine diffusive, Gaussian-quadratic and affine jump-diffusive 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 specification testing and (parametric) model selection within the term structure literature.

Keywords: Bonds; Treasury bonds (search for similar items in EconPapers)
Date: 2006
New Economics Papers: this item is included in nep-fmk, nep-mst and nep-rmg
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Citations: View citations in EconPapers (19)

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Related works:
Journal Article: Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models (2010)
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 (2007)
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