FRBSF Economic Letter
2000-04; February 18, 2000
 Economic
Letter Index
Volatility Spillovers in the U.S. Treasury Market
The U.S. Treasury market is the largest and most active debt market in
the world with about $3.6 trillion of tradable securities outstanding
as of September 1999. Treasury securities are traded almost around the
clock, starting in Tokyo, then moving to London, and then on to New York.
Given this market structure, the prices and hence the yields on Treasury
securities can readily incorporate economic announcements and other developments
when they become known. For example, on August 27, 1998, Treasury yields
fell sharply in overseas trading due to Russia's suspension of trading
in the ruble and reports of weak economic growth from South Korea and
Malaysia. When financial markets opened later that day in New York, that
information had already been incorporated into Treasury yields, although
they continued to fall in light of other financial news.
This Economic Letter reports on research by Fleming and Lopez
(1999) that examines the linkages between the three geographical segments
of the Treasury market. Specifically, they focus on the volatility of
Treasury yields, that is, the variance of the changes in Treasury yields
observed in each market segment. Previous research indicates that yield
volatility exhibits patterns that can be readily modeled. Using standard
econometric models, the authors find that the volatility of the yield
changes that occur during the New York trading hours directly affects
(or "spills over" into) the yield volatility experienced during the overseas
trading hours. The intuition for this result is that market developments
during the New York trading hours contain important information that continues
to affect yield volatilities in the subsequent trading hours.
The authors also find that the yield volatilities experienced during
the Tokyo and London trading hours spill over into each other but do not
have a detectable effect on the volatility experienced during the New
York trading hours. Two major reasons for this asymmetry in volatility
spillovers are the preponderance of major U.S. economic announcements
made during the New York trading hours and the concentration of Treasury
investors within the United States. These results suggest that the information
generated during the New York trading hours generally has the greatest
impact on Treasury yield volatility and on the Treasury market more generally.
This result contrasts with other research on the foreign exchange market,
also an around-the-clock financial market that finds volatility spillovers
among all of the market segments.
The around-the-clock market for Treasury
securities
Trading in Treasury securities is conducted over the counter and not
on an established financial exchange. The major market makers are the
30 primary government securities dealers, who are financial firms that
interact directly with the Federal Reserve Bank of New York in the course
of the Fed's open market operations. According to Dupont and Sack (1999),
the primary dealers averaged $193 billion in daily transactions during
the second quarter of 1999. The core of the Treasury market (and the main
source of research data) is the interdealer broker market, which accounts
for over 90% of trading between dealers and about 40% of total trading.
Interdealer brokers, who are independent of the primary dealers, collect
and post dealer quotes and execute trades between dealers, thereby facilitating
information flows in the market and providing anonymity to the trading
dealers. The brokered market is extremely liquid and is characterized
by large minimum trade sizes, small bid-ask spreads, and modest brokerage
fees.
Trading takes place 23 hours a day during the week in the three trading
centers, as shown in the figure.
(Note that there is no trading on weekends and that trading decreases
to 22 hours a day when New York switches to eastern daylight saving time.)
The global trading day begins in Tokyo at 8:30 a.m. local time (6:30 p.m.
eastern standard time (EST)) and continues until roughly 5:00 p.m. (3:00
a.m. EST). Trading then passes to London, where it is 8:00 a.m. At about
12:30 p.m. London time, trading passes to New York, where it is 7:30 a.m.
EST, and continues until roughly 5:30 p.m. Regardless of location, the
trading process is the same; the same Treasury securities are traded by
the same dealers through the same interdealer brokers with the same brokerage
fees. Trades agreed upon during the Tokyo and London trading hours typically
settle in the same way as New York trades, which is one business day later
in New York through the Government Securities Clearance Corporation.
Trading volume in the Treasury market is highly concentrated with, on
average, about 94% of trades taking place in New York, 4% in London and
2% in Tokyo. This concentration is due in part to the release of U.S.
macroeconomic announcements during New York trading hours, which can often
lead to sharp price revisions and surges in trading volume. Fleming and
Remolona (1997) find that several announcements, such as the producer
price index and consumer price index announcements, are associated with
sharp changes in Treasury yields. The fixed hours of Treasury futures
trading on the Chicago Board of Trade (8:20 a.m.-3:00 p.m. EST) and the
predominance of U.S. institutions as owners of Treasury securities (approximately
60% of the amount outstanding) also contribute to this trading concentration.
A related feature of the Treasury market is the higher yield volatility
experienced during the New York trading hours. As indicated by Fleming
(1997), the average absolute yield change, a common measure of yield volatility,
for the five-year Treasury note is about 6.2 basis points for New York
trading, but it is just about 1.4 basis points for both the Tokyo and
London trading hours.
Modeling volatility spillovers
The data used by Fleming and Lopez to model the market segments' yield
volatilities are based on trading in the interdealer broker market from
February 24, 1992, to August 19, 1994, a total of 635 trading days. The
source of the data is GovPX, Inc., a joint venture by the primary dealers
and interdealer brokers to improve the public's access to Treasury prices
and yields. GovPX consolidates and posts real-time quote and transactions
data from five of the six major interdealer brokers, accounting for roughly
two-thirds of the trading volume in the interdealer broker market. The
study focuses on the yields of the five-year Treasury note as well as
those of the two- and ten-year notes. The five-, two-, and ten-year notes
were the most actively traded securities during the sample period, accounting
for about 25%, 20%, and 15% of total trading volume, respectively. They
were also the most actively traded in each of the three market segments
in the same order.
For each market segment, the yield change is calculated as the difference
between the last transaction yield of that segment's trading hours and
the last transaction yield of the previous segment's trading hours. Missing
yields due to holidays in individual trading centers are filled in with
the last yield of the previous market segment, effectively imposing a
zero yield change. Per-hour volatility for each market segment is then
computed as the square of the segment's yield change divided by the number
of trading hours during that market segment. The length of the Tokyo trading
hours is measured from the New York close and is typically 9.5 hours.
The London and New York trading hours are defined to be 4.5 and 10 hours,
respectively. (Note that since this is an over-the-counter market, the
lengths of the segments' trading hours are necessarily approximate.)
For this data set, the average yield changes for the five-year Treasury
note are basically zero for the New York and Tokyo market segments, but
slightly positive for the London market segment. The preponderance of
large yield movements during New York trading hours is clearly demonstrated
by the segments' average per-hour volatilities, which are 0.3 for Tokyo,
0.6 for London, and 4.1 for New York. Similar quantitative results are
found for the two- and ten-year Treasury notes.
In order to test for volatility spillovers in the Treasury market, the
authors use a modified version of the standard GARCH model, which characterizes
the dynamics in a market segment's per-hour yield volatility as a function
of the segment's previously observed, squared yield changes. For their
model, the authors introduce additional terms representing the squared
yield changes from the other two segments' trading hours. For example,
the model for today's Treasury yield volatility during the New York trading
hours is a function of past squared New York yield changes and the squared
yield changes from today's Tokyo and London trading hours. If the coefficients
on the two out-of-market yield terms are positive and statistically significant,
then volatility from these market segments can be said to spill over into
the third market segment. If the coefficients are not statistically significant,
then the null hypothesis that volatility spillovers are present is rejected.
Empirical results
The empirical results for the five-year Treasury notes are reported here
and are qualitatively similar to those of the two- and ten-year notes.
For the Tokyo market segment, the coefficients on the squared New York
and London yield changes were significant at the 10% level, while for
the London market segment the coefficients on the squared Tokyo and New
York yield changes were significant at the 5% level. These results indicate
that volatility spillovers into these market segments are present; that
is, information generated outside of these market segments has an impact
on their within-market yield volatilities. However, for the New York market
segment, the coefficients on both the squared Tokyo and London yield changes
are not significant at the 10% level. Volatility spillovers are thus not
indicated for the New York market segment; only information generated
during its own trading hours is relevant for modeling its volatility dynamics.
These findings for the Treasury market contrast with those for the foreign
exchange market, which is another around-the-clock financial market. For
this market, Engle, Ito, and Lin (1990) found that each market segment's
volatility was affected by all the other segments' squared price changes.
The differences in information arrival in these two markets may explain
the contrasting results. While the foreign exchange market has a basically
constant level of volatility and information arrival across trading hours,
Treasury yield volatility is highest during New York trading hours, largely
due to macroeconomic announcements made during those hours. It seems reasonable
that volatility spillovers emanating from New York would occur in the
Treasury market and be readily detectable, while spillovers into New York
do not occur or are not easily detectable due to the greater degree of
information generated during those hours.
Since trading volume is a key difference between the Treasury market
segments, the authors extend their analysis to include lagged, own-market
trading volume into the model. In both the Tokyo and London market segments,
volatility spillovers are still present for the five-year Treasury yield,
even after adjusting for the effect of trading volume. For the New York
market segment, the coefficient on the lagged trading volume is not significant,
and the null hypothesis of volatility spillovers is again rejected. The
results for the two- and ten-year Treasury yields are qualitatively similar.
Conclusion
The Treasury market presents researchers with an opportunity to examine
how around-the-clock trading affects market volatility. Previous research
on the foreign exchange market indicates that volatility spillovers are
present for all market segments. However, the authors reach a different
conclusion for the Treasury market. They find that volatility spillovers
are present for the Tokyo and London market segments but do not detect
such spillovers for the New York market segment. The main reason for these
results is that information arrival in the Treasury market, as gauged
by the release of U.S. macroeconomic announcements and trading volume,
is highly concentrated during the New York trading hours. Thus, spillovers
from New York into the overseas market segments seem more likely to occur
and easier to detect than spillovers from overseas into the New York market
segment. Additional research into the microstructure characteristics of
this global financial market, such as the degree of market liquidity in
these market segments, is needed to further explain the dynamics in Treasury
yield volatility.
Jose A. Lopez
Economist
References
Dupont, D., and B. Sack. 1999. "The Treasury Securities Market: Overview
and Recent Developments." Federal Reserve Bulletin (December)
pp. 785-806.
Engle, R.F., T. Ito, and W. Lin. 1990. "Meteor Showers or Heat Waves?
Heteroskedastic Intra-Daily Volatility in the Foreign Exchange Market."
Econometrica 58, pp. 525-542.
Fleming, M.J. 1997. "The
Round-the-Clock Market for U.S. Treasury Securities." Federal Reserve
Bank of New York Economic Policy Review (July) pp. 9-32.
Fleming, M.J., and J.A. Lopez. 1999. "Heat
Waves, Meteor Showers and Trading Volume: An Analysis of Volatility Spillovers
in the U.S. Treasury Market." Federal Reserve Bank of San Francisco
Working Papers in Applied Economic Theory 99-09.
Fleming, M.J., and E. Remolona. 1997. "What
Moves the Bond Market?" Federal Reserve Bank of New York Economic
Policy Review (December) pp. 31-50.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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