Identifying volatility risk premia from fixed income Asian options
AbstractFixed income options are frequently adopted by companies to hedge interest rate risk. Their payoff dependence on the cumulative short-term rate makes them particularly informative about interest rate volatility risk. Based on a joint dataset of bonds and Asian interest rate options, we study the interrelations between bond and volatility risk premia in a major emerging fixed income market. We propose a dynamic term structure model that generates an incomplete market compatible with a preliminary empirical analysis of the dataset. Approximation formulas for at-the-money Asian option prices avoid the use of computationally intensive Fourier transform methods, allowing for an efficient implementation of the model. The model generates a bond risk premium strongly correlated with a widely accepted emerging market benchmark index (EMBI-Global), and a negative volatility risk premium, consistent with the use of Asian options as insurance in this market.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 33 (2009)
Issue (Month): 4 (April)
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Web page: http://www.elsevier.com/locate/jbf
Asian options Risk premium Stochastic volatility Incomplete markets;
Other versions of this item:
- Caio Ibsen R. Almeida & José Valentim M. Vicente, 2007. "Identifying Volatility Risk Premium from Fixed Income Asian Options," Working Papers Series 136, Central Bank of Brazil, Research Department.
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