Can You Derive Market Volatility Forecasts from the Observed Yield Curve Convexity Bias?
Wesley Phoa Vice President, Research Capital Management Sciences Suite 300, 11766 Wilshire Boulevard Los Angeles, CA 90025 phone (310) 479 9715 fax (310) 479 6333 ABSTRACT In theory, long bond yields incorporate a convexity adjustment reflecting anticipated volatility in the bond market, making it possible to deduce the market’s expectations about long-term volatility from the shape of the yield curve. This has been carried out using a four factor yield curve model derived from an expectations theory of the term structure, which can accommodate a bond market risk premium. Analysis of 1953-1996 US Treasury bond data shows that expected volatility is sometimes efficiently priced into bond yields, and sometimes barely priced in at all: there are two distinct regimes which seem to alternate. INTRODUCTION The yield on a 30-year Treasury bond is often, but not always, lower than the yield on a 20-year bond. A common and plausible explanation is that since the 30-year bond has more convexity
