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Term Structure Movements Implicit in Option Prices

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  • Caio Ibsen R. Almeida
  • José Valentim M. Vicente

Abstract

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.

Suggested Citation

  • Caio Ibsen R. Almeida & José Valentim M. Vicente, 2006. "Term Structure Movements Implicit in Option Prices," Working Papers Series 128, Central Bank of Brazil, Research Department.
    • Handle: RePEc:bcb:wpaper:128
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    File URL: https://www.bcb.gov.br/content/publicacoes/WorkingPaperSeries/wps128.pdf
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    References listed on IDEAS

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    1. Viera Neto, C. A. & Pedro L. Valls Pereira, 1999. "Closed Form Formula for the Arbitrage Free Price of an Option for the One Day Interfinancial Deposits Index," Finance Lab Working Papers flwp_8, Finance Lab, Insper Instituto de Ensino e Pesquisa.
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    Cited by:

    1. Allan Jonathan da Silva & Jack Baczynski & José Valentim Machado Vicente, 2020. "Efficient Solutions for Pricing and Hedging Interest Rate Asian Options," Working Papers Series 513, Central Bank of Brazil, Research Department.
    2. Vicente, José & Tabak, Benjamin M., 2008. "Forecasting bond yields in the Brazilian fixed income market," International Journal of Forecasting, Elsevier, vol. 24(3), pages 490-497.
    3. 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.
    4. Daniela Kubudi & José Valentim Vicente, 2016. "A Joint Model of Nominal and Real Yield Curves," Working Papers Series 452, Central Bank of Brazil, Research Department.
    5. José Valentim Machado Vicente, 2021. "A Non-Knotty Inflation Risk Premium Model," Working Papers Series 543, Central Bank of Brazil, Research Department.

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    1. Claudio Henrique Barbedo & Octávio Bessada Lion & Jose Valentim Machado Vicente, 2010. "Pricing Asian Interest Rate Options with a Three-Factor HJM Model," Brazilian Review of Finance, Brazilian Society of Finance, vol. 8(1), pages 9-23.

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