Trading Strategies Based on Term Structure Model Residuals

Abstract

The term structure of interest rates is an important input for basically every pricing model and is mostly calibrated on coupon bond prices. Therefore the estimated interest rates should accurately explain the market prices of these bonds. However nearly all empirical papers on interest rate estimation, e.g. Svensson (1994), report significant pricing errors in their sample. So an important question is what drives these pricing errors of the bonds. One simple explanation would be different tax treatment or different liquidity but most papers on this research topic, e.g. Elton and Green (1998), cannot fully explain the observed pricing errors. Therefore these errors must be at least partially caused by either model misspecification or by the deviation of particular bond prices from general market conditions (mispricing). We provide empirical evidence for the German government bond market that risk-adjusted trading strategies based on bond pricing errors can yield about 15 basis points p.a. abnormal return compared to benchmark portfolios. Furthermore the abnormal returns are continuously achieved over the whole time period and not randomly on a few days and show a relation to changes in the level and the curvature of the term structure of interest rates. Therefore pricing errors seem to contain some economic information about deviations of bond prices from general market conditions and are not exclusively caused by model misspecification and/or differences in liquidity and tax treatment of individual bonds.