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Term Structure Movements Implicit in Option Prices

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  • Caio Ibsen R. Almeida
  • José Valentim M. Vicente

Abstract

This paper analyzes how including options in the estimation of a dynamic term structure model impacts the way it captures term structure movements. Two versions of a multi-factor Gaussian model are compared: One adopting only bonds data, and the other adopting a joint dataset of bonds and options. Term structure movements extracted under each version behave distinctly, with slope and curvature presenting higher mean reversion rates when options are adopted. The composition of bond risk premium is also affected, with considerably more weight attributed to the level factor when options are included. The inclusion of options in the estimation of the dynamic model also improves the pricing of out-of-sample options.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps128.pdf
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Bibliographic Info

Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 128.

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Date of creation: Dec 2006
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Handle: RePEc:bcb:wpaper:128

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Web page: http://www.bcb.gov.br/?english

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Cited by:
  1. Vicente, José & Tabak, Benjamin M., 2008. "Forecasting bond yields in the Brazilian fixed income market," International Journal of Forecasting, Elsevier, vol. 24(3), pages 490-497.
  2. Almeida, Caio & Vicente, José, 2009. "Are interest rate options important for the assessment of interest rate risk?," Journal of Banking & Finance, Elsevier, vol. 33(8), pages 1376-1387, August.

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