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

73 Pages Posted: 28 Jun 2019 Last revised: 8 Aug 2019

See all articles by Gurdip Bakshi

Gurdip Bakshi

Fox School of Business

John Crosby

University of Maryland - Robert H. Smith School of Business

Xiaohui Gao Bakshi

University of Maryland - Department of Finance

Date Written: August 6, 2019

Abstract

We formalize the notion of local time risk premium in the context of a theory in which the pricing kernel is a general diffusion process with spanned and unspanned components. We derive results on the expected excess return of options on bond futures. These results are organized around our new empirical finding that the average returns of out-of-the-money puts and calls on Treasury bond futures are both negative. Our theoretical reconciliation warrants a negative local time risk premium, and our treatment considers models with market incompleteness and sources of volatility uncertainty.

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

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

University of Maryland - Department of Finance ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

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