Discussion Paper Details

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Title: The Term Structure of Government Debt Uncertainty

Author(s): Antonio Mele, Yoshiki Obayashi and Shihao Yang

Publication Date: July 2019

Keyword(s): fixed income volatility, government bond variance swaps, information content of government bond volatility and Treasury markets

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Mele, A, Obayashi, Y and Yang, S. 2019. 'The Term Structure of Government Debt Uncertainty'. London, Centre for Economic Policy Research.