Term Structure and Volatility: Lessons from the Eurodollar Markets

65 Pages Posted: 8 Jul 2004

Date Written: July 7, 2004

Abstract

We evaluate the ability of several affine models to explain the term structure of the interest rates and option prices. Since the key distinguishing characteristic of the affine models is the specification of conditional volatility of the factors, we explore models which have critical differences in this respect: Gaussian (constant volatility), stochastic volatility, and unspanned stochastic volatility models. We estimate the models based on the Eurodollar futures and options data. We find that both Gaussian and stochastic volatility models, despite the differences in the specifications, do a great job matching the conditional mean and volatility of the term structure. When these models are estimated using options data, their properties change, and they are more successful in pricing options and matching higher moments of the term structure distribution. The unspanned stochastic volatility (USV) model fails to resolve the tension between the futures and options fits. Unresolved tension in the fits points to additional factors or, even more likely, jumps, as ways to improve the performance of the models. Our results indicate that Gaussian and stochastic volatility models cannot be distinguished based on the yield curve dynamics alone. Options data are helpful in identifying the differences. In particular, Gaussian models cannot explain the relationship between implied volatilities and the term structure observed in the data.

Suggested Citation

Bikbov, Ruslan and Chernov, Mikhail, Term Structure and Volatility: Lessons from the Eurodollar Markets (July 7, 2004). Available at SSRN: https://ssrn.com/abstract=562454 or http://dx.doi.org/10.2139/ssrn.562454

Ruslan Bikbov

Columbia Business School ( email )

420 West 118th Street
New York, NY 10027
United States

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

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