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Bond Variance Risk Premiums

58 Pages Posted: 2 Jan 2012 Last revised: 23 Nov 2016

Hoyong Choi

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM)

Philippe Mueller

London School of Economics & Political Science (LSE) - Department of Finance

Andrea Vedolin

Boston University - Department of Finance & Economics

Date Written: November 15, 2016

Abstract

This paper studies variance risk premiums in the Treasury market. We first develop a theory to price variance swaps and show that the realized variance can be perfectly replicated by a static position in Treasury futures options and a dynamic position in the underlying. Pricing and hedging is robust even if the underlying jumps. Using a large options panel data set on Treasury futures with different tenors, we report the following findings: First, the term structure of implied variances is downward sloping across maturities and increases in tenors. Moreover, the slope of the term structure is strongly linked to economic activity. Second, returns to the Treasury variance swap are negative and economically large. Shorting a variance swap produces an annualized Sharpe ratio of almost two and the associated returns cannot be explained by standard risk factors. Finally, the returns remain highly statistically significant even when accounting for transaction costs and margin requirements.

Keywords: Variance risk premium, Treasury implied volatility, Treasury variance swap

JEL Classification: E43, G12

Suggested Citation

Choi, Hoyong and Mueller, Philippe and Vedolin, Andrea, Bond Variance Risk Premiums (November 15, 2016). Available at SSRN: https://ssrn.com/abstract=1787478 or http://dx.doi.org/10.2139/ssrn.1787478

Hoyong Choi

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Philippe Mueller (Contact Author)

London School of Economics & Political Science (LSE) - Department of Finance ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Andrea Vedolin

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

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