DP13874 The Term Structure of Government Debt Uncertainty

Author(s): Antonio Mele, Yoshiki Obayashi, Shihao Yang
Publication Date: July 2019
Date Revised: January 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 government bond volatility and provides predictions on the fair value of government bond variance swaps and derivatives referenced thereon. Our calibrated model predicts that expected volatilities frequently oscillate between episodes of backwardation and contango, a feature that is in stark contrast with dynamics observed in equity markets. We use the model in risk-management experiments and evaluate scenarios such as the reaction of the U.S. Treasury volatility curve to shocks including unanticipated Fed decisions or global economic imbalances. Unlike equity volatility dynamics, which may be specified exogenously without violating no-arbitrage conditions, government bond volatility must be consistent with the dynamics of the whole yield curve. The paper provides quasi-closed form solutions that can readily be implemented despite the high-dimensional no-arbitrage restrictions that underlie the model dynamics.