Term Structure Movements Implicit in Option Prices
This paper analyzes how including options in the estimation of a dynamic term structure model impacts the way it captures term structure movements. Two versions of a multi-factor Gaussian model are compared: One adopting only bonds data, and the other adopting a joint dataset of bonds and options. Term structure movements extracted under each version behave distinctly, with slope and curvature presenting higher mean reversion rates when options are adopted. The composition of bond risk premium is also affected, with considerably more weight attributed to the level factor when options are included. The inclusion of options in the estimation of the dynamic model also improves the pricing of out-of-sample options.
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