Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models

We propose using model-free yield quadratic variation measures computed from intraday data as a tool for specification testing and selection of dynamic term structure models. We find that the yield curve fails to span realized yield volatility in the U.S. Treasury market, as the systematic volatility factors are largely unrelated to the cross-section of yields. We conclude that a broad class of affine diffusive, quadratic Gaussian, and affine jump-diffusive models cannot accommodate the observed yield volatility dynamics. Hence, the Treasury market per se is incomplete, as yield volatility risk cannot be hedged solely through Treasury securities.