Excess yields in bond hedging
Litterman & Scheinkman (1991) showed that the term structure of interest rates is reliablymodelled by an affine three-factor model using principal component analysis. Such a modelis inconsistent with no arbitrage. Here, Haim Reisman and Gady Zohar derive an explicitformula for the theoretical rate of profit from such arbitrage, use historical data of USTreasuries to estimate its parameters, and find that the excess returns predicted by theirformula are surprisingly large. Moreover, the returns that are obtained in practice are inagreement with the predicted ones. Their result can be applied to improve hedging and beata benchmark portfolio
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