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Unspanned Stochastic Volatility in Affine Models: Evidence from Eurodollar Futures and Options

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Author Info

  • Ruslan Bikbov

    ()
    (Federal Reserve Board, Washington, DC 20551)

  • Mikhail Chernov

    ()
    (London Business School and CEPR, London NW1 4SA, United Kingdom)

Abstract

Unspanned stochastic volatility (USV) refers to the inability of bonds to replicate volatility-sensitive derivative securities. Affine term structure models require special restrictions on the parameters to exhibit USV. We use a joint Eurodollar futures and options data set to estimate affine three-factor models with and without USV restrictions. The unrestricted model captures prices of futures and options well. Option pricing errors are much larger in the USV model. The USV model is rejected in favor of the unrestricted model based on the likelihood ratio and Wald tests. We use the implications of the unrestricted model as a benchmark for understanding the extant evidence that favors USV. Specifically, we replicate extant tests in samples simulated from the unrestricted model. We show that none of the existing findings contradict the model without USV restrictions.

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File URL: http://dx.doi.org/10.1287/mnsc.1090.1020
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 55 (2009)
Issue (Month): 8 (August)
Pages: 1292-1305

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Handle: RePEc:inm:ormnsc:v:55:y:2009:i:8:p:1292-1305

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Keywords: economics; econometrics; finance; asset pricing; simulation; statistical analysis;

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Cited by:
  1. Lucio Sarno & Paul Schneider & Christian Wagner, 2012. "Properties of Foreign Exchange Risk Premiums," Working Paper Series 10_12, The Rimini Centre for Economic Analysis.
  2. Collin-Dufresne, Pierre & Goldstein, Robert S. & Jones, Christopher S., 2009. "Can interest rate volatility be extracted from the cross section of bond yields?," Journal of Financial Economics, Elsevier, vol. 94(1), pages 47-66, October.
  3. Philippe Mueller & Andrea Vedolin & Yu-min Yen, 2012. "Bond Variance Risk Premia," FMG Discussion Papers dp699, Financial Markets Group.
  4. Ho, Hsiao-Wei & Huang, Henry H. & Yildirim, Yildiray, 2014. "Affine model of inflation-indexed derivatives and inflation risk premium," European Journal of Operational Research, Elsevier, vol. 235(1), pages 159-169.
  5. Christensen, Jens H.E. & Lopez, Jose A. & Rudebusch, Glenn D., 2014. "Can spanned term structure factors drive stochastic yield volatility?," Working Paper Series 2014-3, Federal Reserve Bank of San Francisco.
  6. Peter Christoffersen & Christian Dorion & Kris Jacobs & Lotfi Karoui, 2014. "Nonlinear Kalman Filtering in Affine Term Structure Models," Cahiers de recherche 1404, CIRPEE.

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