Unspanned Stochastic Volatility from an Empirical and Practical Perspective

41 Pages Posted: 15 Dec 2015 Last revised: 27 Aug 2019

Date Written: August 26, 2019


I study the relationship between interest rates and interest-rate volatility, particularly the idea of unspanned stochastic volatility (USV): volatility risk that cannot be hedged with bonds or swaps. Simulated data is used to assess the ability of regression-based techniques, popular but controversial in the literature, to identify and measure USV. With this backing, I consider data from several modern interest-rate markets, and find volatility to be largely, and often fully, unspanned. By comparing hedged and unhedged returns of interest-rate options, I assess volatility risk relative to interest-rate risk, providing a conceptual framework with quantitative guidelines.

Keywords: Interest-rate volatility, Unspanned stochastic volatility, Volatility risk, Hedging, Market completeness, Term structure models

JEL Classification: C63, E43, G12, G13

Suggested Citation

Backwell, Alex, Unspanned Stochastic Volatility from an Empirical and Practical Perspective (August 26, 2019). Available at SSRN: https://ssrn.com/abstract=2701911 or http://dx.doi.org/10.2139/ssrn.2701911

Alex Backwell (Contact Author)

University of Cape Town ( email )

University of Cape Town
Cape Town, Western Cape 7700
South Africa

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