DP13874 The Term Structure of Government Debt Uncertainty

Author(s): Antonio Mele, Yoshiki Obayashi, Shihao Yang
Publication Date: July 2019
Date Revised: April 2020
Keyword(s): fixed income volatility, government bond variance swaps, information content of government bond volatility, Treasury markets
JEL(s): E43, E44, G12, G13
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13874

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.