Hedging in fixed income markets and bond variance risk premia

OMI Seminar Series

Using data from 1983 to 2012, we propose a new fear measure for Treasury markets, akin to the VIX for equities, labeled TIV. We then construct Treasury bond variance risk premia as the difference between the implied variance and an expected variance estimate using autoregressive models. Bond variance risk premia display pronounced spikes during crisis periods. We show that variance risk premia encompass a broad spectrum of macroeconomic uncertainty. Uncertainty about the nominal and the real side of the economy increase variance risk premia but uncertainty about monetary policy has a strongly negative effect. We document that bond variance risk premia predict excess returns on Treasuries, stocks, corporate bonds and mortgage-backed securities, both in-sample and out-of-sample.

We document and high correlation between the TIV and refinancing activity in the mortgage market. To further investigate this link, we incorporate the demand and supply effects resulting from dynamic hedging of mortgage-backed securities into an otherwise standard one factor dynamic term structure model. The model replicates salient features of the data: Violation of the expectations hypothesis and the tent-shaped feature of forward rates. We also get time-varying second moments of bond yields and the variation in bond return volatility driven by hedging commands a variance risk premium.


Philippe Mueller (LSE)

Tuesday, January 29, 2013 - 14:15
to 15:15