Decomposing Long Bond Returns: A Decentralized Modeling Approach

70 Pages Posted: 5 Aug 2019 Last revised: 28 Aug 2020

See all articles by Peter Carr

Peter Carr

New York University Finance and Risk Engineering

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: July 31, 2019

Abstract

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

Carr, Peter P. and Wu, Liuren, Decomposing Long Bond Returns: A Decentralized Modeling Approach (July 31, 2019). Baruch College Zicklin School of Business Research Paper No. 2019-08-06, Available at SSRN: https://ssrn.com/abstract=3430004 or http://dx.doi.org/10.2139/ssrn.3430004

Peter P. Carr

New York University Finance and Risk Engineering ( email )

6 MetroTech Center
Brooklyn, NY 11201
United States
9176217733 (Phone)

HOME PAGE: http://engineering.nyu.edu/people/peter-paul-carr

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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