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Are Interest Rate Options Important for the Assessment of Interest Rate Risk?

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  • Caio Almeida
  • José Vicente

Abstract

Fixed income options contain substantial information on the price of interest rate volatility risk. In this paper, we ask if those options will provide information related to other moments of the objective distribution of interest rates. Based on a dynamic term structure model, we find that interest rate options are useful for the identification of interest rate quantiles. A three-factor model with stochastic volatility is adopted and its adequacy to estimate Value at Risk of zero coupon bonds is tested. We find significant difference on the quantitative assessment of risk when options are (or not) included in the estimation process of the dynamic model. Statistical back tests indicate that bond estimated risk is clearly more adequate when options are adopted, although not yet completely satisfactory.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps179.pdf
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Bibliographic Info

Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 179.

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Date of creation: Jan 2009
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Handle: RePEc:bcb:wpaper:179

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Cited by:
  1. Jang, Bong-Gyu & Yoon, Ji Hee, 2010. "Analytic valuation formulas for range notes and an affine term structure model with jump risks," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2132-2145, September.
  2. Realdon, Marco, 2009. ""Extended Black" term structure models," International Review of Financial Analysis, Elsevier, vol. 18(5), pages 232-238, December.
  3. Wright, Jonathan H. & Zhou, Hao, 2009. "Bond risk premia and realized jump risk," Journal of Banking & Finance, Elsevier, vol. 33(12), pages 2333-2345, December.

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