Caio Almeida (IBMEC Business School - Rio de Janeiro) Jeremy J. Graveline (Stanford Graduate School of Business) Scott Joslin (Stanford Graduate School of Business)
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There is strong empirical evidence that risk premia in long-term interest rates are time-varying. These risk premia critically depend on interest rate volatility, yet existing research has not examined the impact of time-varying volatility on excess returns for long-term bonds. To address this issue, we incorporate interest rate option prices, which are very sensitive to interest rate volatility, into a dynamic model for the term structure of interest rates. We estimate three-factor affine term structure models using both swap rates and interest rate cap prices. When we incorporate option prices, the model better captures interest rate volatility and is better able to predict excess returns for long-term swaps over short-term swaps, both in- and out-of-sample. Our results indicate that interest rate options contain valuable information about risk premia and interest rate dynamics that cannot be extracted from interest rates alone.
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Paper provided by Economics Research Group, IBMEC Business School - Rio de Janeiro in its series IBMEC RJ Economics Discussion Papers with number
2005-04.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
John H. Cochrane & Monika Piazzesi, 2002.
"Bond Risk Premia,"
NBER Working Papers
9178, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Other versions:
John H. Cochrane & Monika Piazzesi, 2005.
"Bond Risk Premia,"
American Economic Review,
American Economic Association, vol. 95(1), pages 138-160, March.
[Downloadable!]
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