Identifying Volatility Risk Premia from Fixed Income Asian Options

43 Pages Posted: 21 Mar 2018

See all articles by Caio Almeida

Caio Almeida

Getulio Vargas Foundation ; Princeton University

Jose Vicente

Government of the Federative Republic of Brazil - Central Bank of Brazil; Ibmec, Rio de Janeiro - IBMEC Business School

Date Written: September 22, 2008

Abstract

Fixed income Asian options are frequently adopted by companies to hedge interest rate risk. Having a payoff structure depending on the cumulative short-term rate makes them particularly informative about interest rate volatility risk. Based on a joint dataset of bonds and Asian interest rate options, we study the inter-relations between bond and volatility risk premiums in a major emerging fixed income market. We propose and implement a dynamic term structure model that generates an incomplete market, compatible with a preliminary empirical analysis of the dataset. Approximation formulas for at-the-money Asian option prices avoid the use of computationally intensive Fourier transform methods, allowing for an efficient implementation of the model. The model generates bond risk premium strongly correlated (89%) with a widely accepted emerging market benchmark index (EMBI-Global), and a negative volatility risk premium, consistent with the use of Asian options as insurance in this market. Volatility premium explains a significant portion (33%) of bond premium, indicating that the Asian options market considerably affects the prices of risk of its neighbor bond market.

Keywords: Asian Options, Risk Premium, Dynamic Term Structure Models, Incomplete Markets

JEL Classification: C13, G12, G13

Suggested Citation

Almeida, Caio and Vicente, Jose, Identifying Volatility Risk Premia from Fixed Income Asian Options (September 22, 2008). Available at SSRN: https://ssrn.com/abstract=3142985 or http://dx.doi.org/10.2139/ssrn.3142985

Caio Almeida (Contact Author)

Getulio Vargas Foundation ( email )

Praia de Botafogo 190, 11o andar
Botafogo
Rio de Janeiro, Rio de Janeiro 22250-900
Brazil
5521-37995827 (Phone)
5521-2553-8821 (Fax)

HOME PAGE: http://www.fgv.br/professor/calmeida/

Princeton University ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States

Jose Vicente

Government of the Federative Republic of Brazil - Central Bank of Brazil

P.O. Box 08670
SBS Quadra 3 Bloco B - Edificio-Sede
Brasilia, Distr. Federal 70074-900
Brazil

Ibmec, Rio de Janeiro - IBMEC Business School

SCN Quadra 2, Bloco A, 2nd. floor
Ed. Corporate Financial Center
Brasília, 707712-900
Brazil

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