The Puzzle of Treasury Option Returns

Abstract

Puzzling to many interest-rate option models, average excess returns of out-of-the-money puts and calls on bond futures are both negative, unconditionally and conditional on economic states. We explore sources of negative average option excess returns and empirically reject hypotheses linked to the predominance of spanned risks. Resolving the puzzle, we develop economically motivated restrictions in the context of a theory in which the pricing kernel is a general diffusion process with spanned and unspanned components. Our reconciliation is a framework that introduces market incompleteness and priced unspanned volatility risks, allowing for time-varying downside and upside futures risk premiums.

Keywords: Options on futures of Treasury bonds, interest-rate models, option risk premiums, unspanned risks in the pricing kernel

JEL Classification: G00, G12, G13, G15