Selecting a Bond-Pricing Model for Trading: Benchmarking, Pooling, and Other Issues

Abstract

Does one make money trading on the deviations between observed bond prices and values proposed by bond-pricing models? We extend Sercu and Wu (1997)'s work to more models and more data, but we especially refine the methodology. In particular, we provide a normal-return benchmark that markedly improves upon the Sercu-Wu ones in terms of noisiness and bias. Trading on the basis of deemed mispricing is profitable indeed no matter what model one uses, and there is remarkably little difference across models, at least when one re-estimates and trades daily. We observe no relation with various measures of fit in the estimation stage. We also obtain an impression as to how much of the typical deviation consists of mispricing and how much is model mis-estimation or mis-specification. Lastly, we find that pooled time-series and cross-sectional estimation, as applied by e.g. De Munnik and Schotman (1994), does help in stabilizing the parameter, but hardly improves the trader's profits.

Keywords: Term Structure of Interest Rates, Bonds

JEL Classification: G12, G14