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Do Options Contain Information About Excess Bond Returns?

Author

Listed:
  • Caio Almeida

    (IBMEC Business School - Rio de Janeiro)

  • Jeremy J. Graveline

    (Stanford Graduate School of Business)

  • Scott Joslin

    (Stanford Graduate School of Business)

Abstract

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.

Suggested Citation

  • Caio Almeida & Jeremy J. Graveline & Scott Joslin, 2005. "Do Options Contain Information About Excess Bond Returns?," IBMEC RJ Economics Discussion Papers 2005-04, Economics Research Group, IBMEC Business School - Rio de Janeiro.
  • Handle: RePEc:ibr:dpaper:2005-04
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    File URL: http://professores.ibmecrj.br/erg/dp/papers/dp200504.pdf
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    References listed on IDEAS

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    Cited by:

    1. 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.
    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.
    3. Ruslan Bikbov & Mikhail Chernov, 2009. "Unspanned Stochastic Volatility in Affine Models: Evidence from Eurodollar Futures and Options," Management Science, INFORMS, vol. 55(8), pages 1292-1305, August.
    4. Peter Feldhütter, 2016. "Can Affine Models Match the Moments in Bond Yields?," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 6(02), pages 1-56, June.
    5. Philippe Mueller & Andrea Vedolin & Yu-min Yen, 2012. "Bond Variance Risk Premia," FMG Discussion Papers dp699, Financial Markets Group.
    6. Don H Kim, 2007. "Spanned stochastic volatility in bond markets: a reexamination of the relative pricing between bonds and bond options," BIS Working Papers 239, Bank for International Settlements.
    7. Jacobs, Kris & Karoui, Lotfi, 2009. "Conditional volatility in affine term-structure models: Evidence from Treasury and swap markets," Journal of Financial Economics, Elsevier, vol. 91(3), pages 288-318, March.

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