Decomposing Long Bond Returns: A Decentralized Modeling Approach
70 Pages Posted: 5 Aug 2019 Last revised: 28 Aug 2020
Date Written: July 31, 2019
This paper develops a decentralized theory that determines the fair value of the yield-to-maturity of a bond or bond portfolio based purely on the near-term dynamics of the yield itself. The theory decomposes the yield into three components: its expected change, its risk premium, and its convexity effects. The convexity effect can be constructed with a historical variance estimator. The expectation can come from statistical models or expert forecasts, leaving the remaining component of the yield as a risk premium estimate. Comparative yield analysis of different bonds can start with commonality assumptions on their risks, risk premiums, and expected change.
Keywords: bond returns, profit and loss attribution, yield decomposition, expectation, risk premium, convexity effects, butterfly trades
JEL Classification: C13, C51, G12, G13
Suggested Citation: Suggested Citation