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Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models
Author(s) -
ANDERSEN TORBEN G.,
BENZONI LUCA
Publication year - 2010
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2009.01546.x
Subject(s) - volatility (finance) , yield curve , affine term structure model , econometrics , treasury , affine transformation , forward volatility , stochastic volatility , quadratic variation , variance swap , volatility smile , volatility swap , economics , implied volatility , mathematics , financial economics , bond , statistics , finance , pure mathematics , archaeology , history , brownian motion
We propose using model‐free yield quadratic variation measures computed from intraday data as a tool for specification testing and selection of dynamic term structure models. We find that the yield curve fails to span realized yield volatility in the U.S. Treasury market, as the systematic volatility factors are largely unrelated to the cross‐section of yields. We conclude that a broad class of affine diffusive, quadratic Gaussian, and affine jump‐diffusive models cannot accommodate the observed yield volatility dynamics. Hence, the Treasury market per se is incomplete, as yield volatility risk cannot be hedged solely through Treasury securities.