Do Options Contain Information About Excess Bond Returns?

Abstract:     
A bond or swap that is sold before it matures has an uncertain return. There is strong empirical evidence that long-term interest rates contain a time-varying risk premium. Interest rate options may contain information about this risk premium because their prices are sensitive to the volatility and market prices of the risk factors that drive interest rates. We ask whether risk premiums estimated using interest rate option prices are better able to predict changes in long-term interest rates. More specifically, we estimate 3-factor affine term structure models using the joint time series of interest rate cap prices and swap rates with different maturities. Our main finding is that the risk premiums estimated using interest rate option prices are better able to predict excess returns, both in- and out-of-sample. In contrast to previous literature, the arbitrage-free models with the most predictive power contain a stochastic volatility component.

working papers series