The effect of interest rate volatility on treasury yields

Abstract

There is a substantial literature on the level and volatility of interest rates. However, there is no agreement to date on the relationship between the two, e.g., whether higher interest rate volatility will result in higher or lower bond yields. Further, there is virtually no research on the role of maturity in this relationship. It is hypothesized that, because of the stochastic nature of interest rates and the embedded option associated with the government's ability to time its borrowings, there should be a negative relationship between interest rate volatility and Treasury yields. Moreover, this negative relationship should be stronger for longer-maturity bonds, everything else held constant. This hypothesis is tested empirically, using bond yield data from the US Treasury market. The main finding is that interest rate volatility does indeed have a significant negative effect on bond yields, and the significance is greater for 20-year bonds than for 10-year bonds, as hypothesized. This result adds a wrinkle to the already complicated policy issue of what range of interest rate volatility is desirable from a ‘social optimum’ standpoint.

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