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Identifying volatility risk premia from fixed income Asian options

Fixed income options are frequently adopted by companies to hedge interest rate risk. Their payoff dependence on the cumulative short-term rate makes them particularly informative about interest rate volatility risk. Based on a joint dataset of bonds and Asian interest rate options, we study the interrelations between bond and volatility risk premia in a major emerging fixed income market. We propose a dynamic term structure model that generates an incomplete market compatible with a preliminary empirical analysis of the dataset. Approximation formulas for at-the-money Asian option prices avoid the use of computationally intensive Fourier transform methods, allowing for an efficient implementation of the model. The model generates a bond risk premium strongly correlated with a widely accepted emerging market benchmark index (EMBI-Global), and a negative volatility risk premium, consistent with the use of Asian options as insurance in this market.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 33 (2009)
Issue (Month): 4 (April)
Pages: 652-661

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Handle: RePEc:eee:jbfina:v:33:y:2009:i:4:p:652-661
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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  1. Hélyette Geman & Marc Yor, 1993. "Bessel Processes, Asian Options, And Perpetuities," Mathematical Finance, Wiley Blackwell, vol. 3(4), pages 349-375.
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