Information in the Term Structure of Yield Curve Volatility
Northwestern University - Kellogg School of Management
Birkbeck, University of London
October 28, 2014
We characterize volatility in the US Treasury market in terms of volatilities of term premia and short-rate expectations, and their conditional covariance. To this end, we propose a no-arbitrage model with stochastically correlated risks which we estimate with extensive second-moment data. Short-rate expectations become more volatile than term premia ahead of recessions and during distress in asset markets. The correlation of premia and expectations is close to zero on average but varies strongly over time and in conjunction with monetary easings and tightenings. While Treasury bonds are nearly unexposed to variance risk, investors pay a large premium for hedging short-rate expectations volatility and covariance shocks via derivatives. We illustrate the distinct behavior of these volatility components during and after the financial crisis, and link it to the measures undertaken by the Fed.
Number of Pages in PDF File: 53
Keywords: interest rate risk, realized yield covariance matrix, affine models, macro uncertainty, liquidity
JEL Classification: E43, C51
Date posted: August 20, 2009 ; Last revised: October 29, 2014
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