DECOMPOSING LONG BOND RETURNS: A DECENTRALIZED THEORY

Abstract

Classic bond pricing links, i.e., centralizes, bond valuation across all maturities by specifying the dynamics of the short-term interest rate. This paper develops a decentralized theory that prices each bond based purely on the near-term behavior of the bond’s own yield. The theory levers the domain expertise of an investor on a particular bond and allows the investor to make pricing and investment analysis on the bond without the shackles of an ambitious centralizing mandate. The theory decomposes the short-term return on a bond with respect to the variation of its own yield. Imposing no dynamic arbitrage on the return decomposition leads to a simple pricing equation relating the bond yield to the market pricing and conditional mean and variance forecasts of the yield’s near-term change. The paper illustrates the theory’s applications in decentralized investment of a single bond and in the construction and investment of decentralized butterfly bond portfolios.