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Instantaneous volatility of the yield curve, variance risk premium and bond return predictability

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  • Yin, Ximing
  • Yang, Ge

Abstract

This paper proposes a new way of estimating the instantaneous volatility of fixed income securities using derivatives data, which can further be used to construct the corresponding yield curve variance risk premium (VRP). We show that this VRP measure exhibits strong long-horizon predictive power for bond excess returns. After controlling for the shape of the yield curve, the VRP strongly predicts 1-year holding period excess returns for 2-year to 10-year zero coupon bonds. The marginal R2 of VRP is as high as 12.6%. One standard deviation increase in the VRP is associated with 2.224% increase in the bond excess return. This result is robust when we include various other bond return predictors, such as the Cochrane–Piazzesi “tent-shaped” factor. The out-of-sample analysis suggests that this predictability is not only statistically significant, but also can be translated into economic gains. Additional tests suggest that this predictability varies with economic conditions.

Suggested Citation

  • Yin, Ximing & Yang, Ge, 2024. "Instantaneous volatility of the yield curve, variance risk premium and bond return predictability," Journal of Empirical Finance, Elsevier, vol. 77(C).
  • Handle: RePEc:eee:empfin:v:77:y:2024:i:c:s0927539824000252
    DOI: 10.1016/j.jempfin.2024.101490
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    More about this item

    Keywords

    Random field; Term structure; Instantaneous volatility; Variance risk premium; Bond return;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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