Everyinvestorowningapartofamunicipalbondportfolio.docVIP

The Impact of Predictability on Empirical Estimates of Municipal Bond Price Volatility and Sensitivity of Price Volatility to Level of Yields by S. Lakshmivarahan George Lynn Cross Research Professor School of Computer Science University of Oklahoma Norman, Oklahoma 73019 and Duane R. Stock* Price Investments Professor 205A Adams Hall Price College of Business University of Oklahoma Norman, Oklahoma 73019 Phone: 405.325.5690 Fax: 405.325.7688 Email: dstock@ January 19, 2007 The latter author wishes to thank the Price College of Business, Center for Financial Studies, and Bank of Oklahoma for support. Matthew Rison, Shengguang Qian, Hamed Bagherpour, and Allison Hock provided valuable research support. Presented at University of Groningen. Comments by Henk von Eije are appreciated. *Please send all correspondence to the last listed author. Key words: volatility, bonds,risk, predictability, ARMA, GARCH, TVPL, municipalThe Impact of Predictability on Empirical Estimates of Municipal Bond Price Volatility and Sensitivity of Volatility to Level of Yields Price volatility (variance) is a common measure of bond risk. Previous analysis has shown price volatility to depend upon duration and the volatility of interest rates. A more complete and accurate second order model shows that price volatility also depends on predicted changes in yield and convexity. Municipal bond price volatility estimated by the more accurate second order model can be much larger (200%) than estimated first order volatility. Analysts using only a first order model can make large errors. Additionally, the effect that level of yields has on price volatility can be very different in first and second order models. Introduction The municipal market is huge ($2.34 trillion) where Hudson and Kim (2007) report it is practically half that of the U.S. government. Every investor owning a part of a municipal bond portfolio should be aware of the risks of their particular portfolio. The m