Do Options Contain Information About Excess Bond Returns?

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.