Models of Conditional Variance for Bond Prices

Abstract

Evidence of predictability of financial time series along with recent advances in modeling time dependent conditional variance clearly call for incorporating such theory into expressions for expected bond price changes and variance of price changes. Thus, we derive new first and second order expressions for conditional variance of price change based on these advances. Among other things, we express conditional variance of price changes as a combination of innovations in simultaneously estimated expected change in yield and conditional variance of yield change. Also, we examine how conditional variance is affected by duration, yield volatility, expected change in yield, and convexity. Portfolio managers can use the results to enhance expected performance analysis. For example, in contrast to many theoretical papers, we find that variance of price changes depends on bond convexity. Bond portfolio managers should thus reassess the role convexity plays in their portfolio choices. That is, they may wish to be compensated for positive convexity in terms of greater expected return or required yield.