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Volatility and Jump Risk Premia in Emerging Market Bonds

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  • John Matovu
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    Abstract

    There is strong evidence that interest rates and bond yield movements exhibit both stochastic volatility and unanticipated jumps. The presence of frequent jumps makes it natural to ask whether there is a premium for jump risk embedded in observed bond yields. This paper identifies a class of jump-diffusion models that are successful in approximating the term structure of interest rates of emerging markets. The parameters of the term structure of interest rates are reconciled with the associated bond yields by estimating the volatility and jump risk premia in highly volatile markets. Using the simulated method of moments (SMM), results suggest that all variants of models which do not take into account stochastic volatility and unanticipated jumps cannot generate the non-normalities consistent with the observed interest rates. Jumps occur (8,10) times a year in Argentina and Brazil, respectively. The size and variance of these jumps is also of statistical significance.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/172.

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    Length: 25
    Date of creation: 01 Jul 2007
    Date of revision:
    Handle: RePEc:imf:imfwpa:07/172

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    Related research

    Keywords: Emerging markets; Bonds; Interest rates; Risk premium; Economic models; bond; bond yields; polynomial; statistics; statistical significance; kurtosis; diffusion model; bond yield; time series; bond prices; econometrics; stochastic model; sampling; brady bond; parameter vector; goodness of fit; financial economics; standard errors; emerging market bonds; central tendency; covariance; equation; characteristic function; skewness; constant variance; bond price; estimation method; probability; standard deviations; arbitrage-free price; statistic; significance level; cash flow; markov chain; normal density; convertible bonds; characteristic functions; derivative; semi nonparametric estimation; poisson processes; gaussian distribution; estimation procedure; martingale; emerging market bond; autocorrelation; correlation; interest rate derivatives; option markets; coupon bond; poisson process; standard deviation; vector autoregression; stock prices; market bond;

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    1. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
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