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

59 Pages Posted: 15 Mar 2007 Last revised: 4 Dec 2022

See all articles by Torben G. Andersen

Torben G. Andersen

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Aarhus University - CREATES

Luca Benzoni

Federal Reserve Bank of Chicago - Research Department

Multiple version iconThere are 2 versions of this paper

Date Written: March 2007

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.

Suggested Citation

Andersen, Torben G. and Benzoni, Luca, Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models (March 2007). NBER Working Paper No. w12962, Available at SSRN: https://ssrn.com/abstract=971598

Torben G. Andersen (Contact Author)

Northwestern University - Kellogg School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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Aarhus University - CREATES ( email )

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Luca Benzoni

Federal Reserve Bank of Chicago - Research Department ( email )

230 South LaSalle Street
Chicago, IL 60604
United States
312-322-8499 (Phone)

HOME PAGE: http://lbenzoni.frbchi.googlepages.com/

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