Are Interest Rate Options Important for the Assessment of Interest Rate Risk?
32 Pages Posted: 21 Mar 2018
Date Written: December 2008
Fixed income options contain substantial information on the price of interest rate volatility risk. In this paper, we ask if those options will also provide information related to other moments of the objective distribution of interest rates. Based on dynamic term structure models within the class of affine models, we find that interest rate options are useful for the identification of interest rate quantiles. Two three-factor models are adopted and their adequacy to estimate Value at Risk of zero coupon bonds is tested. We find significant difference on the quantitative assessment of risk when options are (or not) included in the estimation process of each of these dynamic models. Statistical backtests indicate that bond estimated risk is clearly more adequate when options are adopted, although not yet completely satisfactory.
Keywords: Dynamic term structure models, Value at risk, Back-testing procedures, Laplace Transform, Feller processes
JEL Classification: C13 , G12 , G13
Suggested Citation: Suggested Citation