Unspanned Risks, Negative Local Time Risk Premiums, and Empirical Consistency of Models of Interest-Rate Claims

59 Pages Posted: 28 Jun 2019 Last revised: 17 Dec 2020

See all articles by Gurdip Bakshi

Gurdip Bakshi

Temple University - Fox School of Business and Management; Fox School of Business

John Crosby

University of Maryland - Robert H. Smith School of Business

Xiaohui Gao Bakshi

Fox School of Business, Temple University

Date Written: August 6, 2019

Abstract

We formalize the notion of local time risk premiums in the context of a theory in which the pricing
kernel is a general diffusion process with spanned and unspanned components. We derive results
pertaining to expected excess returns of options on bond futures. These results are organized
around our finding that average returns of out-of-the-money puts and calls on bond futures
are both negative, the consistency of which is examined through unconditional and conditional
exercises. Our theoretical reconciliation warrants negative local time risk premiums, and our
treatment considers models with market incompleteness, volatility uncertainty, and time-varying
sign of futures risk premium.

Keywords: Expected Return of Options on Treasury Bond Futures, Unspanned Components of Pricing Kernel, Interest-Rate Models, Tanaka’s Formula, Local Time Risk Premiums

JEL Classification: G00, G12, G13, G15

Suggested Citation

Bakshi, Gurdip S. and Crosby, John and Gao, Xiaohui, Unspanned Risks, Negative Local Time Risk Premiums, and Empirical Consistency of Models of Interest-Rate Claims (August 6, 2019). Available at SSRN: https://ssrn.com/abstract=3410542 or http://dx.doi.org/10.2139/ssrn.3410542

Gurdip S. Bakshi

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

John Crosby (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
+447979901892 (Phone)

HOME PAGE: http://www.john-crosby.co.uk/

Xiaohui Gao

Fox School of Business, Temple University ( email )

Philadelphia, PA 19122
United States

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