Work

Do Bonds Span the Fixed Income Markets? Theory and Evidence for Unspanned Stochastic Volatility

Year: 2002

Type: article

Abstract: ABSTRACT Most term structure models assume bond markets are complete, that is, that all fixed income derivatives can be perfectly replicated using solely bonds. How ever, we find that, in practice, swap rates have limited explanatory power for returns on at‐the‐money straddles—portfolios mainly exposed to volatility risk. We term this empirical feature unspanned stochastic volatility (USV). While USV can be captured within an HJM framework, we demonstrate that bivariate models cannot exhibit USV. We determine necessary and sufficient conditions for trivariate Markov affine systems to exhibit USV. For such USV models, bonds alone may not be sufficient to identify all parameters. Rather, derivatives are needed.

Source: The Journal of Finance

DOI: 10.1111/1540-6261.00475

Authors: Pierre Collin‐Dufresne, Robert S. Goldstein

Institutions: Carnegie Mellon University, Pennsylvania State University, University of Connecticut, University of Illinois Urbana-Champaign, Washington University in St. Louis, University of Rochester, Columbia University, Stanford University

Language: English

Topic: Stochastic processes and financial applications

Subfield: Finance

Field: Economics, Econometrics and Finance

Domain: Social Sciences

Open Access status: green

OpenAlex ID: W2064545790

FWCI: 16.42

Cites: 52

Cited by: 322

Related to: 10