Government Bonds and Time-Deposits

This chapter builds on the general framework of Chap. 2 , and develops indexes of expected volatility in government bond and time deposit markets. Variance contract design and pricing in these markets are plagued by two major complexities that are absent in the interest rate swap (Chap. 3 ) and equity cases. First, variance pricing in these markets rely on options referencing bond or time deposit futures where the options and futures often have different maturities (e.g. one-month options on two-month futures). Second, typically available for trading are American-style options, whereas model-free variance pricing requires European-style exercise features. We analyze the impact of the maturity mismatch and exercise style of the options on variance pricing. In addition to the usual percentage and basis point volatility formulations, this chapter derives indexes of expected volatility expressed in terms of basis point yield volatility.