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The Term Structure of Government Debt Uncertainty

Author

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  • Mele, Antonio
  • Obayashi, Yoshiki
  • Yang, Shihao

Abstract

How valuable would it be to mitigate government debt volatility? This paper introduces a model that accounts for the complex structure of expected volatility in government bond markets and provides predictions regarding the fair value of derivatives referenced to this expected volatility. The model predicts that, unlike equity markets, futures markets on government bond volatilities frequently oscillate between episodes of backwardation and contango. This property helps explain events such as the reaction of the U.S. Treasury volatility curve to shocks including unanticipated Fed decisions or global economic imbalances. The paper provides quasi-closed form solutions that can readily be implemented despite the high-dimensional no-arbitrage restrictions that underlie the model dynamics.

Suggested Citation

  • Mele, Antonio & Obayashi, Yoshiki & Yang, Shihao, 2019. "The Term Structure of Government Debt Uncertainty," CEPR Discussion Papers 13874, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:13874
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    References listed on IDEAS

    as
    1. Mark Britten‐Jones & Anthony Neuberger, 2000. "Option Prices, Implied Price Processes, and Stochastic Volatility," Journal of Finance, American Finance Association, vol. 55(2), pages 839-866, April.
    2. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    3. Mele, Antonio, 2007. "Asymmetric stock market volatility and the cyclical behavior of expected returns," Journal of Financial Economics, Elsevier, vol. 86(2), pages 446-478, November.
    4. Ho, Thomas S Y & Lee, Sang-bin, 1986. "Term Structure Movements and Pricing Interest Rate Contingent Claims," Journal of Finance, American Finance Association, vol. 41(5), pages 1011-1029, December.
    5. repec:bla:jfinan:v:59:y:2004:i:4:p:1481-1509 is not listed on IDEAS
    6. Bakshi, Gurdip & Madan, Dilip, 2000. "Spanning and derivative-security valuation," Journal of Financial Economics, Elsevier, vol. 55(2), pages 205-238, February.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Fixed income volatility; Information content of government bond volatility; Government bond variance swaps; Treasury markets;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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