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Identifying Volatility Risk Premium from Fixed Income Asian Options

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

We provide approximation formulas for at-the-money asian option prices to extract volatility risk premium from a joint dataset of bonds and option prices. The dynamic model generates stochastic volatility and a time-varying volatility risk premium, which explicitly depends on the average cross section of bond yields and on the time series behavior of option prices. When estimated using a joint dataset of Brazilian local bonds and asian options, the model generates bond risk premium strongly correlated (89%) with a widely accepted emerging markets benchmark index, and a negative volatility risk premium implying that investors might be using options as insurance in this market. Volatility premium explains a significant portion (32.5%) of bond premium, confirming that options are indeed important to identify risk premium in dynamic term structure models.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps136.pdf
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Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 136.

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Date of creation: May 2007
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Handle: RePEc:bcb:wpaper:136
Contact details of provider: Web page: http://www.bcb.gov.br/?english

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