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Do Options Contain Information About Excess Bond Returns?

  • Caio Almeida

    (IBMEC Business School - Rio de Janeiro)

  • Jeremy J. Graveline

    (Stanford Graduate School of Business)

  • Scott Joslin

    (Stanford Graduate School of Business)

There is strong empirical evidence that risk premia in long-term interest rates are time-varying. These risk premia critically depend on interest rate volatility, yet existing research has not examined the impact of time-varying volatility on excess returns for long-term bonds. To address this issue, we incorporate interest rate option prices, which are very sensitive to interest rate volatility, into a dynamic model for the term structure of interest rates. We estimate three-factor affine term structure models using both swap rates and interest rate cap prices. When we incorporate option prices, the model better captures interest rate volatility and is better able to predict excess returns for long-term swaps over short-term swaps, both in- and out-of-sample. Our results indicate that interest rate options contain valuable information about risk premia and interest rate dynamics that cannot be extracted from interest rates alone.

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Paper provided by Economics Research Group, IBMEC Business School - Rio de Janeiro in its series IBMEC RJ Economics Discussion Papers with number 2005-04.

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Date of creation: 30 Nov 2005
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Handle: RePEc:ibr:dpaper:2005-04
Contact details of provider: Postal: Av. Pres. Wilson 118, 11 andar, Rio de Janeiro, RJ, Brazil, 20030-020
Web page: http://professores.ibmecrj.br/erg/

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  1. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  2. Shiller, Robert & Campbell, John, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Scholarly Articles 3221490, Harvard University Department of Economics.
  3. Ravi Jagannathan & Andrew Kaplin & Steve Guoqiang Sun, 2001. "An Evaluation of Multi-Factor CIR Models Using LIBOR, Swap Rates, and Cap and Swaption Prices," NBER Working Papers 8682, National Bureau of Economic Research, Inc.
  4. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  5. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
  6. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
  7. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
  8. Jarrow, Robert & Rudd, Andrew, 1982. "Approximate option valuation for arbitrary stochastic processes," Journal of Financial Economics, Elsevier, vol. 10(3), pages 347-369, November.
  9. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
  10. Patrick Cheridito & Damir Filipovic, 2004. "Market Price of Risk Specifications for Affine Models: Theory and Evidence," Econometric Society 2004 North American Winter Meetings 536, Econometric Society.
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