Journal article

Unspanned stochastic volatility from an empirical and practical perspective


Publication Details

Author list: Backwell A

Publisher: Elsevier

Publication year: 2021

Journal: Journal of Banking and Finance

Volume number: 122

Issue number: 105993

Start page: 1

End page: 14

Total number of pages: 14

ISSN: 0378-4266

URL: http://www.elsevier.com/locate/jbf


Abstract

Article history: Received 10 February 2020 Accepted 26 October 2020 Available online 27 October 2020

JEL classification: C63 E43 G12 G13 Keywords: Interest-rate volatility Unspanned stochastic volatility Volatility risk Hedging Market incompleteness Term structure models

I conduct a simulation study to address concerns raised in the empirical literature on unspanned stochas- tic volatility (USV, i.e., interest-rate-volatility risk that cannot be hedged with bonds or swaps). Regres- sions have been the popular method of identifying and measuring USV, and have led to a consensus that is in favour of USV models. Despite plausible challenges to this approach, my simulations show that regressions are able to correctly identify the presence and absence of USV. This relies on a number of methodological considerations which are inconsistent in the literature. Regression results from empirical data, from several modern interest-rate markets, resemble results from data simulated from USV models. I then assess the economic significance of USV. By comparing hedged and unhedged returns of market interest-rate options, I develop quantitative guidelines around how unspanned volatility risk compares to interest-rate risk.

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Keywords

Finance, Statistical Finance


Last updated on 2021-09-03 at 12:44