Information in the Term Structure of Yield Curve Volatility

Abstract

We decompose conditional volatilities of US Treasury yields into components due to short-rate expectations and term premia. To this end, we propose a novel no-arbitrage model which we estimate with extensive second-moment data. Short-rate expectations become more volatile than premia before recessions and during asset market distress. The correlation between shocks to premia and expectations is close to zero on average and varies with stance of monetary policy. While Treasuries are nearly unexposed to variance shocks, investors pay a large premium for hedging variance risk with derivatives. We illustrate the distinct dynamics of those yield volatility components during and after the financial crisis.

Keywords: yield curve, stochastic volatility

JEL Classification: E43, C51