Treasury Option Returns and Models with Unspanned Risks

78 Pages Posted: 28 Jun 2019 Last revised: 28 Sep 2023

See all articles by Gurdip Bakshi

Gurdip Bakshi

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

John Crosby

University of Maryland - Robert H. Smith School of Business

Xiaohui Gao

Fox School of Business, Temple University

Jorge Wolfgang Hansen

Aarhus University - Department of Economics and Business Economics; Aarhus University; Danish Finance Institute (DFI)

Date Written: August 6, 2019

Abstract

We document the phenomenon that average excess returns of out-of-the-money puts and calls on
bond futures are negative, both unconditionally and conditionally on economic states. To explain these findings, 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. The estimated model shows consistency with data on bond yields, yield volatilities, bond futures return volatilities, option prices, and option risk premiums.

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

JEL Classification: G00, G12, G13, G15

Suggested Citation

Bakshi, Gurdip S. and Bakshi, Gurdip S. and Crosby, John and Gao, Xiaohui and Hansen, Jorge Wolfgang, Treasury Option Returns and Models with Unspanned Risks (August 6, 2019). Accepted at Journal of Financial Economics (JFE), 2023, 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

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

Philadelphia, PA 19122
United States

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 )

Alter Hall 421
Philadelphia, PA 19122
United States

HOME PAGE: http://https://sites.google.com/site/xiaohuigaobakshi/

Jorge Wolfgang Hansen

Aarhus University - Department of Economics and Business Economics ( email )

Fuglesangs Allé 4
Aarhus V, 8210
Denmark

Aarhus University ( email )

Nordre Ringgade 1
DK-8000 Aarhus C, 8000
Denmark

Danish Finance Institute (DFI) ( email )

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